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இ朌
Private
Wealth
Management
(1)
•
•
ٖҀ৉व͵୐३‫ݾ‬ਃ૏ࢋׁઐ٤
‫ݟ‬৒৔‫͵ޑ‬ԧч‫ם‬؆‫֢י‬ધ؆ஓПғਸ਼ધЋЏ澝Ԁғ֢எ୐壝ЋЏͺପଋ),'І঴澝И֢
ࡨӆѫઋ٤ͧ)6'ͨ澝ચӴђЏ૏ࠀ
•
ٖҀ৔‫ؼ߀͵ޑ‬৺й‫ࡋ؍‬Ԣ‫ޢ‬ѫઋ٤зԇ۱‫ؙ‬ઋୂ澝ޯԢࡋଳѣЏ‫߆૆ٷ‬ԇୂͫђз՟ঝҸ
՛ङ‫૆ݶ‬Ӄ‫ٗٷ‬ҁͺ࣫‫ܛ‬Ѡ߮Ї١Ҹ՛܎૏ୂ৆ࣲͫિુ՟ঝ‫ם‬ҡ‫ډ‬੧Џ‫૆ٷ‬ாऩ澞মઋ
ર‫ޞ‬૝ଋ‫ͫޞش‬ર३ࢎ‫ࢋͫۤޣޱ‬Չ؆մࠪଌ澞
),'Ѕঃ‫׀‬੟஍ࣹ
•
੣‫੿ܪ‬स͵),'ી‫ܕ‬澝ߓञ澝ѣЏ澝੨ࣿ)6'ѫઋ澝ી঒
•
ާԆ‫͵ېؙ‬И֢ୣ੧澝‫ٺ‬ՇચӴ澝И֢‫ڏ‬ગୣ੧澝И֢ٗ֌ୣ੧澝сପୣ੧澝‫֌ܥ‬ୣ੧澝ӌ
Џୣ੧澝Їࢁୣ੧澝‫࡭ٵן‬ґக澝‫؍ٵ‬ચӴ澝‫؍⩧ࡪ֢ئ‬ঈ澞
ઔ٤͹ஸ朌
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Topic in CFA Level III
Session
Content
Study Session 1-2
ETHICS & PROFESSIONAL STANDARDS (1)&(2)
Study Session 3
THE ASSET MANAGEMENT INDUSTRY AND PROFESSIONALISM ǏNewǐ
Study Session 4
BEHAVIORAL FINANCE
Study Session 5-6
PRIVATE WEALTH MANAGEMENT (1)&(2)
Study Session 7
PORTFOLIO MANAGEMENT FOR INSTITUTIONAL INVESTORS
Study Session 8
APPLICATIONS OF ECONOMIC ANALYSIS TO PORTFOLIO MANAGEMENT
Study Session 9-10
ASSET ALLOCATION AND RELATED DECISIONS AND IN PORTFOLIO
MANAGEMENT (1)&(2)
Framework
¾ SS5: Private Wealth Management (1)
• R10 Managing Individual Investor
Portfolios
Private Wealth
Management (1)
• R11 Taxes and Private Wealth
Management in a Global Context
• R12 Estate Planning in a Global
Context
Study Session 11-12 FIXED-INCOME PORTFOLIO MANAGEMENT (1)&(2)
Study Session 13-14 EQUITY PORTFOLIO MANAGEMENT (1)&(2) ǏNewǐ
Study Session 15
ALTERNATIVE INVESTMENTS FOR PORTFOLIO MANAGEMENT
Study Session 16
RISK MANAGEMENT
Study Session 17
RISK MANAGEMENT APPLICATIONS OF DERIVATIVES
Study Session 18
TRADING ǏNewǐ
Study Session 19
PERFORMANCE EVALUATION ǏNewǐ
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Framework
Reading
10
1. The Portfolio Management Process
2. Profiling Individual Investors
3. 6 factors in Investment Policy Statements
4. Choosing the Optimal Asset Allocation
5. Monte Carlo simulation
6. 6 steps to formulate individual’s IPS
Managing Individual Investor Portfolios
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The Portfolio Management Process 1
The Portfolio Management Process 2
¾ Steps
z Planning
¾
9 Specify investor’s objectives and constraints;
9 Create the investment policy statement (IPS) – formal document in
governing all investment decision making, with a central role in the
whole portfolio management process;
9 Formalize capital market expectations;
Objectives
• Return
9 Required vs. Desired
9 Real vs. Nominal
9 Pre- vs. Post-tax total
• Risk tolerance
9 Ability & willingness
¾
Constraints
• Time horizon(s)
• Liquidity needs
• Taxes
• Legal & Regulatory needs
• Unique circumstances
9 Create the strategic asset allocation.
z Execution
9 Portfolio selection/composition (portfolio manager);
IPS
9 Portfolio implementation (trading desk).
RR
z Feedback
TTLLU
9 Evaluation, monitoring, & rebalancing.
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Profiling Individual Investors 1
Stage of Life
Situational profiling
Reasonably
objective
¾ Source of Wealth
z Entrepreneurial activity (normally above-average willingness to tolerate
risk);
z Inheritance, one-time windfalls, built up over long periods of safe
employment (passively, below-average willingness to tolerate risk).
¾ Measure of wealth
z Positive correlation between level of risk tolerance & client’s perception
of wealth.
¾ Stage of life: (typically reduced willingness to take risk)
z Foundation phase;
z Accumulation phase;
z Maintenance phase (retirement);
z Distribution phase.
¾ During the foundation phase of life, the individual is establishing the base
from which wealth will be created.
z The individual is usually young, with a long time horizon, which normally
would be associated with an above-average tolerance for risk.
¾ In the accumulation phase, earnings accelerate as returns accrue from the
marketable skills and abilities acquired during the foundation period and
gradually reach their peak.
¾ During the maintenance phase, the individual has moved into the later
years of life and usually has retired from daily employment or the pressures
of owning a business.
¾ In the distribution phase, accumulated wealth is transferred to other
persons or entities.
¾ In each of the above phases, personal circumstances are a driving force in
how an individual responds to each cycle of life.
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Profiling Individual Investors 2
Personality Types
• Focus on minimizing risk;
Psychological profiling
Bridges gap between
traditional
& behavioral finance
More
subjective
Decisions based mainly on
thinking/analysis
Methodical
Decisions based mainly on
feeling
Cautious
• Low turnover & low volatility.
• Conservative nature combined with a focus on gathering as
much data as possible. (Less risk averse);
Methodical
Cautious
More risk •Rely on hard facts
averse •Decisions tend to be
conservative in nature
Spontaneous
•Not afraid of making
•Follow investment fads
Less risk
independent investment decisions
averse
•High turnover & trading costs
•Have confidence in their hard
•Risk less important
work/insights
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• Do their own research and rarely form emotional
attachment;
•Can over-analysis, but once
decisions made portfolios tend to
have low turnover & volatility
Individualistic
• Difficulty in making investment decision;
• Constantly on the lookout for new, better information.
• Do their own research and confident in own ability (Less
Individualistic
risk averse);
• Self-assured investors.
Spontaneous
• Buy latest hot investment;
• High turnover & trading costs (Less risk averse).
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Return Objective - RRTTLLU
Risk Objective - RRTTLLU
¾ Return objective
Risk objective (Tolerance)
z Required Return
9 Asset needs
Maintain the inflation-adjusted value
Ability
Willingness
Asset appreciation
„ Time horizon & ability to take risk positively related;
Specific targets
„ Portfolio size & ability to take risk positively related;
9 Cash Flow needs
„ Goal importance & ability to take risk negatively
related;
Support … …
„ Spending needs & ability to take risk negatively
z Desired Return
related;
9 Non-primary goal
„ Relates to client’s
psychological
profile;
„ Asset turn over &
investment style.
„ Flexibility can increase the ability to take risk.
*Conflict between willingness & ability, follow the narrower of the two.
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Investment Constraints 1 - RRTTLLU
Time Horizon
„ New time horizon each time
an investor’s circumstances
change significantly (e.g. prior
to retirement/post
retirement);
„ Length of each time horizon is
important;
„ Other individuals can
influence time horizon.
Investment Constraints 2 - RRTTLLU
Tax Considerations
„ Is investor a taxpayer? Whether annual
portfolio returns subject to taxation;
„ Always strive to minimize current
taxes (e.g., loss harvesting, long-term
gains);
„ Tax-free securities attractive subject to
yield types of tax: income, capital
gains, wealth- transfer, wealth;
„ If tax treatment uncertain,
recommendation for legal counsel.
Liquidity Needs
„ How quickly an asset can be
converted into cash without a
loss in value. Focus is on need
for cash in the short term in
excess of cash in- flows from
earnings or portfolio income.
Consider
„ Ongoing expenses (living
expenses, on-going medical
expenses for loved ones);
„ Major planned outlays (vacation,
new home, charitable
donations…);
„ Emergency needs: 3-6 m living
expenses (medical expense,
uninsured losses,
unemployment…).
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Legal & Regulatory
„ Most frequently involve taxation
and the transfer of personal
property ownership;
„ Two aspects for individual
investors: personal trust and family
foundation;
„ Prudent investor rule;
„ Balance the interests of the income
beneficiary and remaindermen
„ Legal counsel is encouraged.
„
„
„
„
„
Unique Circumstances
Guidelines for social;
Special purpose investing;
Assets legally restricted from sale;
Directed brokerage arrangements;
Privacy concerns.
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Choosing the Optimal Asset Allocation
Monte Carlo Simulation and the Advantages
¾ You are sometimes given characteristics for 5 or 6 portfolios and asked
to select the best portfolio for the client
Selection by a process of elimination.
Eliminate
z Those that fail to meet the after-tax return
objective (calculations may be necessary)
z Those that violate shortfall statement
(usually expressed as maximum allowable
loss) using safety first rule;
z Any allocation that includes disallowed
asset classes
z Any allocation that fails to meet liquidity
requirements
z Always minimize cash (3-6 months’ living
expense)
If more than one allocation
remainsˈUse Sharpe Ratio to
choose between them
Sharpe ratio
r rf
V
¾ Monte Carlo simulation: the process by which probability “distributions”
are arrayed to create path-dependent scenarios to predict end-stage
results.
¾ It is generally superior to steady state, or deterministic, forecasting because
it incorporates the consequences of variability across long-term
assumptions and the resulting path dependency effect on wealth
accumulation.
¾ Monte Carlo analysis is computer and data intensive, so its availability for
personal retirement planning at affordable cost is a direct result of the
availability of inexpensive computing power.
¾ Monte Carlo estimation, in contrast, allows for the input of probability
estimates over multi-period time frames and generates a probability
distribution of final values rather than a single point estimate.
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Monte Carlo Simulation and the Advantages
¾ Assumption
z A Monte Carlo analysis provides a probability estimate, as well as other
detailed information, that allows the investor to better assess risk (for
example, percentiles for the distribution of retirement income).
¾ Monte Carlo analysis is far more informative about the risk associated
with meeting objectives than deterministic analysis.
z The investor can then respond to such risk information by changing
variables under her control.
¾ An advisory module may present a range of alternative asset
allocations and the associated probabilities for reaching goals and
objectives.
Monte Carlo Simulation and the Advantages
¾ A clearer understanding of short-term and long-term risk can be
gained.
z For example, reducing the holdings of risky stock would reduce the
short-term variability of the portfolio but increase the long-term risk of
not having sufficient assets.
¾ It is superior in assessing multi-period effects.
z Traditional analysis projects portfolio return as a simple weighted
average of the asset returns, geometrically compounded. Risk (variance)
is the traditional formula taught in the CFA curriculum.
z Monte Carlo simulation can better model the real stochastic process
where return over time depends not only on the starting value of the
period but also on the additions or withdrawals to the portfolio at each
future period.
¾ Points along the timeline can be considered to answer questions
z Do savings need to be increased?
z Can I retire earlier?
z Must I retire later?
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Monte Carlo Simulation – Disadvantages
¾ Monte Carlo simulation can be a useful tool for investment analysis but like
6 steps to formulate individual’s IPS
¾ 6 steps to formulate personal IPS
any investment tool it can be used either appropriately or inappropriately.
z First, any user of Monte Carlo should be wary of a simulation tool that
Investors classify
relies only on historical data;
z Second, a manager who wants to evaluate the likely performance of a
client’s portfolio should choose a Monte Carlo simulation that simulates
Renew the objectives …
the performance of specific investments, not just asset classes;
IPS
z Third, any Monte Carlo simulation used for advising real-world investors
must take into account the tax consequences of their investments.
Constraints (T&L)
Cash flow analysis
&
Total Investable
Assets estimation
Calculate Returns
Risks (2i2d)
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Investor’s IPS - 1
Investor’s IPS - 2
¾ Return objectives
z Personal investor
¾ Investor classify
z Personal investor
¾ Source of wealth
z Employee with annual salaries
z Own invest-able asset (deposit)
z Trust distribution/Inherit money/one-time windfall
¾ Size of wealth
z There is one-time windfall, size is large
z or size will be small
¾ Stage of life
z The pre-retirement period is long
z There is also the period after retirement
¾ Personal considerations
z With children – education expenses
z With mortgage – liquidity needs
z With tax
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Always just covered
by salary in exam
¾ Asset
z Maintain the inflation-adjusted value
z Asset appreciation
z Specific targets
¾ Cash flow needs
z Support living expense (now and retirement)
z Support mortgage – liquidity needs
z Support children’s education
z Support parents’ living expense
z Support families’ health care expense
z Support insurance premium payment
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Investor’s IPS - 3
Investor’s IPS - 4
¾ Cash flow analysis
z Personal investor 1
¾ Cash flow analysis
Time
¾ Cash inflow
z Salary
z Trust distributions/inheritance
z Other cash inflow (dividends/interest payment)
¾ Cash outflow
z Tax
z Living expense
z Down payment at T0
z Mortgage payment from T1
z Donation just on T0 or from T0 to Tn
z Other one-time need now
¾ Net cash flow
z Net CF at T0 > 0, as a part of TIA
z Net CF from T1 < 0, as the liquidity needs
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T0
T1
Salary
S
S * (1+f)
Trust / inheritance
G
0
S+G
S * (1+f)
Inflow
Total inflow
Outflow
Tax
S*t
S * (1+f) * t
Living expense
L
L * (1+f)
Down payment
D
0
Mortgage payment
0
MG
Charity donation
C
0
Other one-time need
T
0
Total outflow
S * t + L + D+ C + T
S * (1+f) * t + L * (1+f) + MG
Net cash flow
Total in – Total out
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Investor’s IPS - 5
Investor’s IPS - 6
¾ Return calculation
z Personal investor
¾ Risk
z Personal investor
¾Ability - 2i
z They have a long time horizon;
z They are young, with more human capital;
z They may get inheritance in future;
z Their job and income are secure;
z Their health insurance is provided.
¾Ability - 2d
z After-tax salary can not cover living expense;
z Sustained Cash flows (Mortgage) must be paid;
z Asset base is small;
z Other uncertainties.
¾Willingness
z Based on “……” in the case.
¾Overall
z The narrow one dominates.
¾ TIA
z Current portfolio’s value
z Net CF in at T0
z Excluding the house and other unavailable Inheritance
¾ Real Return
Rr
Net CFs at T1
TIA
¾ Nominal Return
Rf
Net CFs at T1
f
TIA
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Investor’s IPS - 7
Investor’s IPS - 8
¾ Investment constraints
¾ Tax
z Liquidity
z The tax rate is … , the tax aspect should be considered;
9 The A need portfolio to provide B for next year’s C
‹A: Name
B: Money C: Use (Mortgage pay)
z The … ‘s tax treatment is uncertain, they need a legal counsel.
¾ Regulations
z The prudent investor rule is applied;
z Time horizon
9 They have a long term two–stage horizon;
9 In the 1st stage, the A must pay B , and also pay C for their D;
z The … need a legal counsel to create a trust to …
¾ Unique
9 In the 2ed stage, they are in retirement, E years from now.
z The … say they do not want to invest in …
‹A: Name B: Living expense, mortgage payment;
z The … want to create a trust to care for …
‹C: Education fee / health care fee;
z The … want to donate … to local charity
‹D: Children / parents;
‹E: How many years from now (30).
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Investor’s IPS - 9
Investor’s IPS - 10
¾ Renew objectives
z Main issue: Renew return objective close to retirement
9 Re-calculate the net CF need annually → PMT
9 Re-calculate the asset base now → PV
9 Calculate the target asset value when retire → FV
9 Calculate the required rate of return → I/Y
¾ New objectives
z Support living expense in retirement
z Support donating money to charity
z Provide inheritance for children
¾ Case analysis Case – 2008 CFA level 3 morning session Q1
QUESTION 1 HAS FOUR PARTS (A, B, C, D) FOR A TOTAL OF 36 MINUTES.
Roberto and Mariana Carvalho live in a large city in Brazil with their two
children, ages four and two. Roberto is 30 years old and Mariana will be
30 years old later this month. Roberto is a manager in a manufacturing
facility and Mariana is a musician in the local symphony orchestra.
Roberto and Mariana’s annual salaries total 120,000 Brazilian reais (BRL)
after tax. Their salaries just cover their living expenses. The average
annual inflation rate is four percent and their salaries and expenses are
expected to increase at this rate. They are healthy and believe their jobs
and earning potential are secure. The Carvalhos’ salaries, dividends, and
interest are taxed at 20 percent, and capital gains at 15 percent.
Mariana’s parents have significant wealth and funded an irrevocable
personal trust for her. Brazil has a wealth transfer tax that applies to
transfers into trusts and to inheritances. Brazil has adopted the Prudent
Investor Rule for the administration of trusts. The current value of the
trust is BRL 1,500,000.
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Investor’s IPS - 10
Investor’s IPS - 10
¾ Case analysis Case – 2008 CFA level 3 morning session Q1(Cont’d)
The terms of the trust state that when Mariana reaches the age of 30, she
will receive a tax-free distribution of half the value of the trust. The
balance of the trust will remain invested and will distribute in total to her
when she reaches age 40. Since she does not have access to the
remaining balance for ten years, this balance is not considered a part of
the Carvalhos’ investable assets, but is part of their total net worth. In
addition, Mariana expects to inherit a substantial sum of money upon the
death of both parents.
The Carvalhos have BRL 500,000 in investable assets, currently all in
short-term bank deposits. It is their intention to maintain at least this
amount in investable assets, on an inflation-adjusted basis, in the future.
The Carvalhos currently live with Mariana’s parents, but are now
purchasing a home. The purchase price of the home is BRL 850,000. The
down payment is 30 percent of the cost of the home and will be funded
from the trust distribution. The Carvalhos will take out a fixed rate
mortgage for the balance of the purchase price. The after-tax mortgage
cost will be fixed at BRL 55,000 (principal and interest) annually for 30
years, with the first annual payment due one year from now.
¾ Case analysis Case – 2008 CFA level 3 morning session Q1(Cont’d)
The Carvalhos’ immediate investment goal is to have their investment
portfolio cover the cost of the mortgage, while maintaining the
portfolio’s inflation-adjusted value. They plan to retire at the age of 60
and their long-term goal is to have an investment portfolio that will
provide an annual income comparable to their current salaries
adjusted by inflation. Their family health insurance is provided by
Roberto’s employer, both now and in retirement. They are hopeful
their two children will attend the local university at no cost. The
university does not charge tuition fees for qualified students who pass
its entrance exam. Those who do not pass the exam are required to
pay full tuition, which is high relative to the Carvalhos’ living expenses.
In order to meet their investment goals, the Carvalhos realize they
need to consider investments other than short-term bank deposits.
The Carvalhos hire Luiz Oliveira, CFA, to manage an investment
portfolio that they will fund with their BRL 500,000 in bank deposits
and the net proceeds of Mariana’s trust distribution at age 30.
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Investor’s IPS - 10
Investor’s IPS - 10
¾ Case analysis Case – 2008 CFA level 3 morning session Q1(Cont’d)
¾ Correct Answer:
A. i. Prepare the return objectives portion of the Carvalhos’ investment
A. i. The return objective for the Carvalhos’ portfolio is to:
policy statement (IPS).
ii. Calculate the after-tax nominal rate of return that is required for the
next year. Show your calculations. (12 minutes)
B. i. Identify two factors in the Carvalhos’ situation that increase their
z Provide for the mortgage payments for a home;
z Support their living expenses in retirement;
z Maintain the inflation-adjusted value of the portfolio.
ability to take risk.
ii. Identify two factors in the Carvalhos’ situation that decrease their
ability to take risk.
iii. Determine whether the Carvalhos have below-average, average, or
above-average ability to take risk.
C. Prepare the following constraints of the Carvalhos’ IPS:
i. Liquidity ii. Time horizon
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Investor’s IPS - 10
A
Investor’s IPS - 10
ii.
Current
A
Year 1
ii. Calculation of Required return
Inflows
Outflows Required Next Year
55,000
Divided by Investable Assets
995,000=
Salary
120,000
124,800
Trust Distributions
750,000
0
870,000
124,800
Required After-Tax Nominal Return—Arithmetic
Calculation of Required return
Total Inflows
Outflows
Living Expenses
120,000
124,800
Down Payment on Home
255,000
0
Mortgage on Home
0
55,000
Total Outflows
375,000
179,800
Net Inflows/ (Outflows)
495,000
(55,000)
Investment Assets
Current Savings Portfolio
500,000
Current Year Net Inflow
495,000
Total Investable Assets
Plus Expected Inflation
4%
Required After-Tax Nominal Return—Geometric
9.53%
1.0553*1.04
Outflows Required Next Year
55,000
Divided by Investable Assets
995,000=
Plus Expected Inflation
9.75%
5.53%
4%
Required After-Tax Nominal Return—Arithmetic
Required After-Tax Nominal Return—Geometric
9.53%
1.0553*1.04
9.75%
Calculation of Required return
995,000
Outflows Required Next Year
55,000
Divided by Investable Assets
995,000=
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5.53%
5.53%
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Investor’s IPS - 10
Investor’s IPS - 10
¾ Correct Answer:
¾ Correct Answer:
Part B: template for Question 1-B
Part B: template for Question 1-B
i. Identify two factors in the Carvalhos’ situation that increase their
ii. Identify two factors in the Carvalhos’ situation that decrease their
ability to take risk
ability to take risk
- They have a long time horizon
- They have a moderate asset base relative to required cash flows
- They are young and have more human capital
- They will receive another trust payout in 10 years
- They will potentially inherit a large sum of money from Mariana’s
parents
from the portfolio;
- There is no assurance the children’s education will be covered by a
scholarship and the cost could be substantial.
iii. Determine whether the Carvalhos have below-average, average or
- They have stable income
above-average ability to take risks (circle one)
Above-average
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Average
Below-average
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Investor’s IPS - 10
Investor’s IPS - 10
¾ Correct Answer:
Part C: template for Question 1-C
Constraint
Prepare the following constraints of the Carvalhos’ IPS
i. Liquidity
The Carvalhos need their investment portfolio to
provide BRL55,000 for next year’s mortgage payment.
ii. Time horizon
The Carvalhols have a long-term multi-stage time
horizon. In the short term, they must pay living
expenses and provide a home for their family. They
may also have to pay tuition for their children. Their
second stage is retirement, thirty years from now.
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¾ Case analysis Case – 2008 CFA level 3 morning session Q1(Cont’d)
Twenty-five years have passed. The Carvalhos are now 55 years old
and their two children are grown and financially independent.
Mariana’s parents passed away earlier this year and left her an
inheritance of BRL 8,000,000 after-tax. The Carvalhos have five years
remaining on their mortgage and the BRL 55,000 annual mortgage
payment will continue to be funded from their investment portfolio.
They intend to work another five years and then retire at age 60.
Their salaries are expected to continue to cover their living expenses
until retirement. Their investment portfolio, including the inheritance,
now totals BRL 10,200,000.
The Carvalhos explain to Oliveira that in retirement, they would like to
maintain their current standard of living and start a regular program
of donating money to their favorite charities. They also hope to leave
an inheritance of BRL 5,000,000 to each of their two children at their
death. Oliveira calculates they will need a portfolio value of BRL
15,000,000 when they retire in order to support these goals.
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Investor’s IPS - 10
Investor’s IPS - 10
¾ Case analysis case – 2008 CFA level 3 morning session Q1(Cont’d)
D. i. Prepare the current return objectives portion of the Carvalhos’ IPS.
ii. Calculate the after-tax nominal rate of return that is required for the
portfolio. Show your calculations.
¾ Correct Answer:
Part D:
i. The revised return objectives for the Carvalhos’ portfolio is to:
- Provide for the mortgage on their home;
- Support their living expenses in retirement;
- Support charitable endeavors in retirement;
- Provide a bequest for their children.
ii. The after-tax nominal rate of return is 8.48%. The return is calculated
using the following inputs:
Mortgage payments remaining
Annual mortgage amount
Investment portfolio value (current)
$10,200,000
Investment portfolio value (target)
$15,000,000
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5
$55,000
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Investor’s IPS - 10
¾ Correct Answer:
Part D:
Using financial calculator, the following figures are used in the
calculation when solving for i:
Reading
N=5, PV=10,200,000, PMT=-55,000, FV=-15,000,000, compute
i=8.48%
11
Or
N=5, PV=-10,200,000, PMT=55,000, FV=15,000,000, compute i=8.48%
Taxes and Private Wealth Management in a Global Context
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Global Taxation Regimes
Framework
1. Global taxation regimes
2. Accrual Taxation
3. Tax drag
4. Deferred capital gain tax
5. Wealth-based taxes
6. Accrual equivalent tax rates
7. Types of investment accounts
8. The tax effects of trading behavior
9. Tax loss harvesting and HIFO Tax Lot
Accounting
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¾ Major sources of government tax revenue include
z Taxes on income
9 These taxes apply to individuals, corporations, and often other types
of legal entities;
9 Income tax structure refers to how and when different types of
income are taxed.
z Wealth-based taxes
9 These include taxes on the holding of certain types of property (e.g.,
real estate) and taxes on the transfer of wealth (e.g., taxes on
inheritance).
z Taxes on consumption
9 Sales taxes are taxes collected in one step from the final consumer
on the price of a good or service;
9 Value-added taxes are collected in intermediate steps in the course
of producing a good or service but borne ultimately by the final
consumer.
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Global Taxation Regimes
Seven Global Tax Regimes
¾ Tax structures vary globally and can change as the needs and objectives of
the governmental jurisdiction change.
¾ Many countries provide special tax provisions for interest income, and
these special provisions include
z An exemption for certain types of interest income;
z A favorable tax rate on interest income;
z An exclusion amount where some limited amount of interest income is
exempt from tax;
z Some fixed income instruments are indexed for inflation and this
inflation adjustment may not be subject to taxation in some jurisdictions.
¾ Dividend income may have special provisions
z In some cases there are exemptions, special tax rates, or exclusions as
described above for interest income;
z In other cases, there may be provisions for mitigating double taxation.
¾ Finally, capital gains (losses) may have special provisions or rates.
¾ Common progressive regime
z This regime has progressive tax rates for ordinary income, but favorable
treatment in all three investment income categories: interest, dividends,
and capital gains;
z This was the most common regime observed.
¾ Heavy dividend tax regime
z This regime has a progressive tax system for ordinary income and
favorable treatment for some interest and capital gains but taxes
dividends at ordinary rates.
¾ Heavy capital gain tax regime
z This regime has a progressive tax system for ordinary income and
favorable treatment for interest and dividends, but taxes capital gains at
ordinary rates.
¾ Heavy interest tax regime
z This regime has a progressive tax system for ordinary income and
favorable treatment for dividends and capital gains, but taxes interest
income at ordinary rates.
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Seven Global Tax Regimes
Seven Global Tax Regimes
¾ Light capital gain tax regime
z This regime has a progressive tax system for ordinary income, interest,
Regime
Ordinary
income tax
structure
Common
progressive
Progressive
Yes
Yes
Yes
Heavy
dividend tax
Progressive
Yes
No
Yes
Heavy capital
gain tax
Progressive
Yes
Yes
No
Heavy interest
tax
Progressive
No
Yes
Yes
Light capital
gain tax
Progressive
No
No
Yes
Flat and light
Flat
Yes
Yes
Yes
Flat and heavy
Flat
Yes
No
No
and dividends, but favorable treatment of capital gains;
z This was the second most commonly observed regime.
¾ Flat and light regime
z This regime has a flat tax system and treats interest, dividends, and
capital gains favorably.
¾ Flat and heavy regime
z This regime has a flat tax system for ordinary income, dividends, and
capital gains;
z It does not have favorable treatment for dividends and capital gains, but
has favorable treatment for interest income.
Favorable
Favorable
treatment for
treatment for
interest income? dividend income?
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Favorable
treatment for
capital gains?
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Accrual Taxation
Tax Drag
¾ The amount of money accumulated for each unit of currency invested
after n years, assuming that returns (after taxes at rate ti are paid) are
reinvested at the same rate of return, r, is simply.
¬ª 1 R R u T ¼º
N
¬ª1 R 1- T ¼º
N
¾ Vladimir Kozloski is determining the impact of taxes on his expected
investment returns and wealth accumulations. Kozloski lives in a tax
jurisdiction with a flat tax rate of 20 percent which applies to all types
¾ Future valueAT = PV[1+R(1-T)]N
of income and is taxed annually. Kozloski expects to earn 7 percent per
¾ Taxes are paid each period, so the periodic return on the account is the
after-tax return, R(1-T);
portfolio of €100,000.
¾ The amount of tax removed from the account each period does not earn
future (compounded) returns.
z The reduction in return caused by the payment of taxes is referred to as
tax drag.
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year on his investment over a 20 year time horizon and has an initial
z What is Kozloski’s expected wealth at the end of 20 years?
z What proportion of potential investment gains were consumed by
taxes?
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Tax Drag
Tax Drag VS Investment Horizon & Return
¾ Accrual tax
¾ Correct Answer:
z Tax drag% > tax rate
z FV €100, 000 u FVIFi
z Investment horizon increase => tax drag $ & % increase
€100, 000 u [1 0.07 u (1 0.2)]20
z Investment return increase
€297,357
z Ignoring taxes, FV = €100,000 [1 +
0.07]20
= €386,968. The
difference between this and the after tax amount accumulated
from above is €89,611. The proportion of potential investment
gains consumed by taxes was €89,611/€286,968 = 31.23 percent.
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Tax drag
(%)
r (%)
2
4
6
8
10
12
14
16
18
=> tax drag $ & % increase
Investment Horizon (years)
5
0.308
0.317
0.325
0.333
0.341
0.348
0.356
0.364
0.371
10
0.319
0.338
0.356
0.375
0.393
0.411
0.429
0.446
0.462
15
0.33
0.359
0.389
0.418
0.446
0.474
0.501
0.526
0.551
20
0.34
0.381
0.421
0.461
0.499
0.535
0.569
0.601
0.631
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25
0.351
0.403
0.454
0.503
0.55
0.593
0.633
0.669
0.701
30
0.362
0.425
0.486
0.545
0.598
0.646
0.689
0.727
0.76
35
0.373
0.447
0.518
0.584
0.643
0.694
0.739
0.776
0.808
40
0.384
0.469
0.549
0.622
0.684
0.737
0.781
0.818
0.848
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Deferred Capital Gain Tax
Cost Basis
¾ Using TCG as the tax rate on capital gains, the after-tax future value
interest factor for deferred capital gains (FVIFCGT) is
FVIFCGT
1 R
N
- ª 1 R
¬
1 R
N
N
- TCG u 1 R
[ 1 R
N
(1- TCG ) TCG ]
N
-1] u T CG º ?
¼
TCG
¾ Summarizing the same three relationships we examined for accrual taxes,
we see that they are quite different when capital gains taxes are applied on
a deferred basis
z Tax drag % = tax rate;
z As the investment horizon increases ֜ tax drag% is unchanged;
z As the investment return increases ֜ tax drag% is unchanged;
¾ In addition, when taxes are deferred
¾ We have assumed that the cost basis for computing taxes is the
investment’s current value ($1,000), as if we invested after-tax dollars.
¾ However, the cost basis is often different from the investment’s current value.
For example, the cost basis could be the original purchase price and the
current value of $1,000 represents the original cost plus unrealized capital
gains.
¾ All else equal, reducing the cost basis increases the realized capital gain,
increases the amount of capital gains taxes due, and reduces the net selling
price. Thus we modify our deferred capital gains tax formula to account
for the basis (B)
FVIFCGT , MV z Basis
z As investment horizon increases ֜ the value of the tax deferral increases;
ª 1 R
¬
N
1 TCG º +TCG B
¼
ª 1 R
¬
N
1 TCG º TCG 1 B TCG
¼
z As investment return increases ֜ the value of the tax deferral increases.
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Wealth-based Taxes
Account Subject to Wealth-based Taxes
¾ In some countries, wealth-based taxes are assessed annually (similar to
accrual income taxes) on the value of assets held. Unlike accrual taxes and
capital gains taxes, which are paid on just the investment return, wealthbased taxes are applied to both the principal and return.
¾ They are most often applied to real estate, as in the U.K. Fortunately the
wealth-based tax rate is usually lower in percentage terms than accrual and
capital gains tax rates.
¾ Continuing the notation from before except that TW is the wealth-based tax
rate, the future value interest factor after the wealth-based tax (FVIFWT)
is
FVIFWT
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[ 1 R (1- TW )]N
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¾ Olga Sanford lives in a country that imposes a wealth tax of 1.0 percent
on financial assets each year. Her €400,000 portfolio is expected to
return 6 percent over the next ten years.
1. What is Sanford’s expected wealth at the end of ten years?
2. What proportion of investment gains was consumed by taxes?
¾ Correct Answer:
For question 1: FV 400,000 u [1.06 u (1- 0.01)]10 647,844
For question 2:
Had the wealth tax not existed, FV = €400,000(1.06)10 = €716,339. This
sum represents a €316,339 investment gain compared to a €247,844
gain in the presence of the wealth tax. Therefore, the one percent
wealth tax consumed 21.65 percent of the investment gain (i.e.,
(€316,339 − €247,844)/€316,339).
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Wealth-based Taxes
Blend Taxing Environments
¾ For wealth-based taxes, the three primary relationships can be
¾ To calculate the after-tax return on the account, we multiply the before
tax return (R) times 1 minus realized tax rate, which considers the proportion
summarized as
of each form of gain with its specific tax rate
z Tax drag % > tax rate;
z As investment horizon increases ֜ tax drag % and tax drag $ increase;
z As investment return increases ֜ tax drag $ increases; tax drag %
decreases.
realized tax rate ( PT
I I PDTD PCGTCG )
¾ The realized tax rate is nothing more than the weighted average tax rate
paid by the investor. P is the weight (proportion) of each type of return,
income, dividend, or realized capital gain, and T is the tax rate on each type
of return. Multiplying each tax rate by the related proportion yields the
weighted average tax rate;
¾ Using the same subscripts for the tax rates, T, as for the proportions, P, the
annual return after realized taxes on interest income, dividends, and realized
capital gains (RART) is
RART
R [1- ( PT
I
I PDTD PCGTCG )]
R 1- realized tax rate
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Blend Taxing Environments
I x Ti
D x Td
CG x TCG
Effective Capital Gain Tax
UCG x TCG
¾ To calculate the effective capital gains tax rate (TECG) that adjusts for the
annual taxes already paid on interest, dividends, and realized capital gains,
we use the following
TECG [1 ( PT
TCG [1 ( PI PD PCG )]
I I PDTD PCGTCG )]
? TECG x
=
TECG
UCG x TCG
TCG
[1 ( PI PD PCG )]
[1 ( PT
I I PDTD PCGTCG )]
¾ Using return after realized taxes (RART) and the effective deferred capital
gains tax rate (TECG), the future value interest factor considering all taxes as
well as the cost basis of the account (FVIFT) is
FVIFT
TECG ª¬1 PT
I I PDTD PCGTCG º
¼ TCG ª¬1 PI PD PCG ¼º
R ART
ª¬(1 RART ) N (1 TECG ) TECG (1 B)TCG º¼
R 1 realized tax rate
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Effective Capital Gain Tax
Effective Capital Gain Tax – Future Value
¾ Assume there is a five-year investment horizon for the account. Annual
accrual taxes will be paid out of the account each year with the
deferred tax on previously unrealized capital gains paid at the end of
the five-year horizon. The account is rebalanced annually. Consider a
€100,000 portfolio with the return and tax profile listed in table below.
What is the expected after-tax accumulation in five years?
Panel A: tax profile
Annual
distribution rate (p)
Tax rate (T)
¾ Correct Answer:
z The annual return after realized taxes, r*, is 0.08[1 − (0.05)(0.35) −
(0.25)(0.15) − (0.45)(0.15)] = 7.02%
z The effective capital gains tax rate, T*, which equals 0.15[(1 − 0.05
− 0.25 − 0.45)/(1 − 0.05 ˜ 0.35 − 0.25 ˜ 0.15 − 0.45 ˜ 0.15)] =
0.15(0.25/0.8775) = 4.27%
z the cost basis and the current market value portfolio are both
€100,000, the cost basis expressed as a percent of current market
value is 1.00.
Ordinary income (i)
5%
35%
z The expected future accumulation of the portfolio in 5 years equals
Dividends (d)
25%
15%
€100,000[(1 + r*)n(1 – T*) + T* − (1 − B)tcg] = €100,000[(1.0702)5(1
Capital gain (cg)
45%
15%
− 0.0427) + 0.0427 − (1 − 1.00)0.15] = €138,662.
Average return (r)
8%
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Accrual Equivalent Tax Rates*
¾ Calculating accrual equivalent tax rates
¾ Kharullah has a balanced portfolio of stocks and bonds, and at the
z The accrual equivalent tax rate can be derived from the accrual
equivalent return, which is a hypothetical tax rate.
z
r u (1 TAE )
RAE o TAE
1
Accrual Equivalent Returns*
RAE
r
z The return may receive preferential tax treatment in either the form of a
reduced rate for dividends or a reduced rate on realized capital gains
combined with valuable deferral for unrealized gains.
z The accrual equivalent tax rate would increase if
beginning of the year, his portfolio has a market value of $100,000, and
the portfolio has an after tax accumulation 5 years of $138,662.
Calculate the RAE for Kharullah.
¾ Correct Answer:
$100,000*(1+RAE)5=$138,662
RAE= 6.756%
9 The return had a larger component taxed at ordinary rates;
9 Dividends and capital gains received less favorable treatment.
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Types of Investment Accounts
¾ Sometimes, the types of investment accounts override the tax treatment of
Types of Investment Accounts
¾ Calculation related to each four accounts
z Taxed annually
an investment based on its asset class;
¾ Taxable accounts: investments are made on an after-tax basis and returns
FVIFAT=[1+R(1-TI)]N
z Taxed deferred account
are taxed in a variety of ways;
¾ Tax-deferred accounts allow tax-deductible contributions and/or taxdeferred accumulation of returns, but funds are taxed when withdrawn;
n
FVIFTDA= 1 + r (1-Tn )
¾ Tax-exempt accounts do not allow tax-deductible contributions, but allow
tax-exempt accumulation of returns even when funds are withdrawn.
FVIFTEA= 1 + r
FVIFTDA=(1+R)N (1-TN)
z Deferred capital gain
FVIFCGBT=[(1+R)N (1-TCG)]+TCGB
z Tax exempt account
FVIFTEA=(1+R)N
n
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Tax Accounts and Investment Risk
=(1+R)N(1-T
¾ FVIF TDA
N)
¾ FVIF TEA=(1-T0)(1+R)N
z If T0 > TN Î FVTDA > FVTEA
z If T0 = TN Î FVTDA = FVTEA
z If T0 < TN Î FVTDA < FVTEA
¾ In taxed account- the government (taxing authority) bears part of the
investment risk;
¾ In tax-exempt account – the investors bears all the investment risk.
z rAT = r (1-t)
Example
¾ Consider an investor with 50 percent of her wealth invested in equities
and 50 percent invested in fixed income, both held in taxable accounts.
The equity has a pretax standard deviation of 20 percent and is
relatively tax-efficient such that all returns are taxed each year at a 20
percent tax rate.
The fixed income is also taxed annually but at a 40 percent rate with
pretax volatility of 5 percent.
If the two asset classes are perfectly correlated, what is the pretax
portfolio volatility?
z σAT = σ (1-t)
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Example
Example
¾ Recall previous example, suppose that the equity is held in a taxable
¾ Correct Answer:
z 0.50(0.20) + 0.50(0.05) = 0.125 = 12.5 percent.
z On an after-tax basis, however, portfolio volatility is 0.50(0.20)(1 −
0.20) + 0.50(0.05)(1 − 0.40) = 0.095 = 9.5 percent.
¾ This example illustrates that annually paid taxes reduce portfolio
volatility.
account and the fixed income is held in a tax-exempt account like those
described in the previous section.
In this case, the investor absorbs all of the bond volatility in the taxexempt account, and what is the new portfolio volatility?
¾ Correct Answer:
z The new portfolio volatility is 0.50(0.20)(1 − 0.20) + 0.50(0.05) = 0.105
= 10.5 percent.
z After-tax volatility increased from the previous measure of after-tax
volatility of 9.5 percent because one of the assets (bonds) became tax
sheltered. The government therefore absorbed less investment risk
through taxes, and the investor is left bearing more investment risk.
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The Tax Effects of Trading Behavior
¾ Investors would place in TDAs and tax-exempt accounts those securities that
would otherwise be heavily taxed if held in taxable accounts.
¾ The taxable account would hold lightly taxed assets. The value created by
using investment techniques that effectively manage tax liabilities is
sometimes called tax alpha.
The Tax Effects of Trading Behavior
¾ In addition to examining asset location as a source of tax minimization, we
can also examine an investor’s trading behavior.
z Traders— trades frequently and recognizes all portfolio returns in the
form of annually taxed short term gains.
9 This equity management style may subject investment returns to tax
¾ In most countries the strategy would be to place equity in taxable accounts,
because their current income is lower than that for bonds and capital gains
can often be deferred. Bonds, with their higher current income, would be
placed in a tax-protected account, such as a TDA.
burdens.
z Active investors— trades less frequently so that gains are longer term
in nature, may receive more favorable tax treatment.
z Passive investors—passively buys and holds the stock.
z Exempt investors— not only buys and holds stocks, but he never pays
capital gains tax.
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Tax Loss Harvesting—HIFO Tax Lot Accounting
¾ Depending on the tax system, investors may be allowed to sell the highest
cost basis lots first (HIFO), which defers realizing the tax liability
associated with lots having a lower cost basis.
¾ Opportunities to create value through tax loss harvesting and HIFO are
greater in jurisdictions with high tax rates on capital gains.
z Tax loss harvesting program can yield substantial benefits;
z The annual tax alpha is largest in the early years and decreases through
Reading
12
time as deferred gains are ultimately realized;
z The complementary strategies of tax loss harvesting and HIFO tax lot
accounting have more potential value when securities have relatively
Estate Planning in a Global Context
high volatility;
z However, harvesting losses is not always an optimal strategy.
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Estate planning
Framework
1. Estate Planning
2. Core Capital
3. Monte Carlo Simulation (MCS)
4. Relative after-tax values
5. Estate planning strategy
6. Estate planning tools
7. Relief from double taxation
¾ Estate planning is the process of preparing for the disposition of one’s
estate (e.g. the transfer of property) upon death and during one’s
lifetime.
z The core document most closely associated with an estate plan is a will
or testament.
9 A will (or testament) outlines the rights others will have over one’s
property after death.
z A testator is the person who authored the will and whose property is
disposed of according to the will.
¾ Probate is the legal process to confirm the validity of the will so that
executors, heirs, and other interested parties can rely on its authenticity.
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Probate
Wealth transfer taxes
¾ A decedent without a valid will or with a will that does not dispose of their
property is considered to have died intestate.
z A court will often decide on the disposition of assets under applicable
intestacy laws during the probate process.
¾ Some individuals may wish to avoid probate.
z Court fees may be sizable, and the process can cause a delay in the
transfer of assets to intended beneficiaries;
z Moreover, many problems can arise in probate when multiple
jurisdictions are involved.
¾ In some instances, probate can be avoided or its impact limited by holding
assets in other forms of ownership
z Joint ownership;
z Living trusts;
z Retirement plans.
¾ Ownership of property is transferred to beneficiaries without the need for
a will and hence the probate process can be avoided or substantially
reduced.
¾ Lifetime gifts are sometimes referred to as lifetime gratuitous transfers,
or inter vivos transfers, and are made during the lifetime of the donor.
z Gifts may or may not be taxed depending on the jurisdiction.
z Taxation may also depend on other factors such as
9 The residency or domicile of the donor;
9 The residency or domicile of the recipient;
9 The tax status of the recipient;
9 The type of asset;
9 The location of the asset (domestic or foreign).
¾ Bequeathing assets or transferring them in some other way upon one’s
death is referred to as a testamentary gratuitous transfer.
z The taxation of testamentary transfers (transfers at death) may depend
upon
9 The residency or domicile of the donor, the residency or domicile of
the recipient;
9 The type of asset;
9 The location of the asset (domestic or foreign).
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Ownership rights
Core capital
¾ Forced heirship rules
z Children have the right to a fixed share of a parent’s estate. This right
may exist whether or not the child is estranged or conceived outside of
¾ Core Capital is the amount of assets (i.e., present value) necessary to
meet all future liabilities
z Retirement expenses and any other needs
¾ Any amount above core capital is considered excess capital
marriage;
z “Claw-back” provisions bring such lifetime gifts back into the estate to
z Excess capital can be transferred to the next generation, charities, etc
calculate the child’s share.
¾ Community property rights
Financial
Capital
z Each spouse has an indivisible one-half interest in income earned during
marriage.
Core capital
¾ Separate property rights
z Each spouse is able to own and control property as an individual, which
PV of all future
liabilities
Human
Capital
Surplus
enables each to dispose of property as they wish, subject to a spouse’s
other rights.
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Example
Core Capital Using a Mortality Table
¾ Husband and wife currently 79 and 68. From the table the wife has a
98.31% probability of living one more year (to age 69) and 90.25%
probability of living 5 more years (to age 73). For the husband the
percentages are 93.55 and 66.86, respectively.
A. Using the table, determine the probability that the husband, wife,
or both live 6 years
B. Using the table, calculate core capital for years if the risk-free rate
is 2%
C. If the family has a portfolio of $1,500,000, determine (based solely
on the information provided) the maximum amount they could
give to charity
¾ Determining the individual’s remaining expected life is a major
problem
z Mortality tables show average remaining years based on attaining
a given age
¾ Correct Answer for A:
z From the mortality table, we see the probability of surviving 6 years
for the husband and wife are 60.01% and 87.85%, respectively. The
probability that one or both will survive 6 years (Comb. Prob.) is
calculated as follows:
z = Prob(husband survives) + Prob(wife survives) - Prob(husband
survives)*Prob(wife survives) = 0.6001+0.8785-(0.6001)(0.8785) =
95.14%
P(A)
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Core Capital Using a Mortality Table
Safety Reserve
¾ Correct Answer for B:
¾ Correct Answer for C:
z The amount of core capital required for 6 years is:
z Mortality tables assume there is 0% probability of living one more
Core Capital 6 years:
than 100 years.
9 In reality there is a non-zero probability.
P(surv t )(spendingt )
;r=real risk-free rate
(1+r)t
P(surv 6 )(spending6 )
P(surv1 )(spending1 )
=
+...+
(1.02)1
(1.02)6
=$1,153,472
6
=¦
z Mortality rates are based on the averages individual’s expected life
t=1
span.
9 Your client could live longer than the average number of years.
z Incorporate a safety reserve into core capital calculations.
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Joint Mortality Probabilities and Core Capital
Monte Carlo Simulation (MCS)
¾ Often utilized in retirement planning to determine the size of the portfolio
¾ Correct Answer:
Yrs
P(AB)
Husband
Wife
Age Prob.
Age Prob.
Comb.
Prob.
Real Annual
Spending
(2%
inflation)
required to meet a desired retirement lifestyle;
Present
Value
Expected
Real
Spending
(2% RFR)
Total
¾ The output is a distribution of portfolio sizes along with their respective
probabilities of meeting the client’s cash flow desires;
¾ Using different portfolio compositions, distributions of possible macro
1
80
0.9355
69
0.9831
0.9989
200,000
199,780
195,863
195,863
variable values, and even variable retirement dates, the simulation indicates
2
81
0.8702
70
0.9649
0.9954
204,000
203,062
195,177
391,040
the probability of each current portfolio allocation meeting the desired
3
82
0.8038
71
0.9457
0.9893
208,080
205,854
193,981
585,021
4
83
0.7339
72
0.9249
0.9800
212,242
207,997
192,157
777,178
5
84
0.6686
73
0.9025
0.9677
216,286
209,494
189,745
966,923
6
85
0.6001
74
0.8785
0.9514
220,816
210,084
186,549
1,153,472
portfolio value at retirement;
¾ The interactions between distribution and sequence of returns can be
perceived by Monte Carlo Simulation, which featured as path dependency;
¾ This represents the probability of ruin, or the probability that his spending
is unsustainable. This analysis incorporates life-span uncertainty as well as
financial market risk(i.e., the probability of depleting one’s financial assets
before death).
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Relative after-tax values
Tax Free Gift
¾ In general, the value of making taxable gifts rather than leaving them in the
estate to be taxed as a bequest, can be expressed as ratio of the after-tax
future value of the gift and the bequest, or:
¾ Whether we use donor or testator, recipient or beneficiary depends on
whether the asset is transferred as a lifetime gift (donor and recipient) or as
part of an estate (testator and beneficiary).
RVtax-free gift =
¾ The basic Equation of the ratio is
n
ª1+rg 1-tig º 1-Tg
FVGift
¼
RVTaxableGift =
=¬
FVBequest ª1+re 1-tie ºn 1-Te
¬
¼
¾ Considering the following scenarios
ʒ Both donor and recipient will not be taxed;
ʓ The recipient pays gift tax and the donor’s estate will not be taxable;
ʔ The donor pays gift tax and the recipient’s estate will not be taxable.
ª1+rg 1-tig º
2.756226
¬
¼
=
n
1.653735
¬ª1+re 1-tie ¼º 1-Te
¾ The formula is as following
¾ The tax-free gift is worth 1.67 times the value of the bequest, so it would
be better to gift the assets immediately than to leave them to the
beneficiary in a will.
¾ It is generally better to transfer high return assets (i.e., growth investments)
to those with the lowest tax rates.
¾ To efficiently allocate the family’s assets, growth investments are gifted to
family members with the lowest tax rates and lower return assets are
bequeathed as part of the estate.
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Example
¾ Consider a Japanese family contemplating a JPY 30 million lifetime
gratuitous transfer in 2009.
RVtaxable gift = FVgift / FVbequest
z JPY 18 million can be transferred free of tax, but the remaining JPY
[1 +rg ( 1 -tig ) ] u ( 1-Tg )
n
12 million transfer is subject to a 50 percent tax rate.
[1 + re ( 1 - t ie ) ] u ( 1-Te )
n
z The same 50 percent rate applies if the gift is delayed and
if rg= re ,t ig= tie
=
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Taxable Gift, paid by receiver
=
FVbequest
n
RVtax-free gift =
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FVtax-free gift
transferred as a bequest, so no tax advantage related to transfer
( 1-Tg )
tax rates exists.
( 1-Te )
z However, if the recipient of the JPY 12 million gift had a lower
marginal tax rate on investment returns (perhaps due to a
progressive income tax schedule) of, say, 20 percent compared to
the estate’s marginal tax rate of, say, 50 percent, the gift can still
create a tax advantage.
¾ Over a ten year horizon, the advantage for locating an asset with an 8
percent pretax return with the donee rather than the donor would be?
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Example
Estate Planning Strategy
¾ A donor is allowed to take a tax deduction in the amount of the charitable
¾ Correct Answer:
z Equation
RVtaxable gift =
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gift.
FVgift
FVbequest
=
[1 +rg ( 1 -tig ) ]n u ( 1-Tg )
[1 + re ( 1 - tie ) ]n u ( 1-Te )
10
ª1+0.08 u 1-0.2 º¼ u 1-0.5
= ¬
=1.256
10
ª1+0.08 u 1-0.5 10 º u 1-0.5
¬
¼
z The lower 20 percent tax rate associated with the gift recipient will
create 25.6 percent more wealth in 10 years than if the asset had
remained in the estate and been taxed at 50 percent annually for
10 years.
¾ Value of a gift to charity relative to leaving it in a bequest
RVcharitable donation=
FVcharitable gift
FVbequest
(1+rg )n+Toi >1+re (1-tie )@ (1-Te )
n
=
>1+re (1-tie )@
n
(1-Te )
z re is pretax return to the estate making the gift;
z tie is the effective tax rates on investment return on the estate making
the gift;
z n is the expected time until the donor’s death at which point the asset
would transfer and be subject to estate tax if it had not been gifted.
z Toi is the tax rate on ordinary income and represents the current income
tax benefit associated with a charitable transfer.
z Te is the estate tax if the asset is bequeathed at death;
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Estate Planning Strategy
Estate Planning Strategy- Generation skipping
¾ Further explanation on the 2nd term of numerator
RVcharitable donation=
FVcharitable gift
FVbequest
¾ Special generation skipping transfer tax is imposed on transfers to, among
(1+rg )n+Toi >1+re (1-tie )@ (1-Te )
n
=
>1+re (1-tie )@
n
(1-Te )
others, grandchildren or subsequent generations and is intended to
produce the same overall tax effect had the assets passed sequentially
through two generations.
z Toi = 1 x Toi represents the current income tax benefit because of the
FVnoskipping=pv ª¬(1+r)n1 (1-t)º¼ ª¬(1+r)n2 (1-t)º¼
charity
FVskipping=pv ¬ª(1+r)N (1-Te )¼º
z Toi [ 1 +re ( 1 – tie ) ]n represents “tax benefit” invested after n years
N=n1+n2
z ( 1 – Te ) represents after estate tax
¾ The relative value of skipping generations to transfer capital that is excess
for both the first and second generations is 1/(1 − T1) where T1 is the tax
rate of capital transferred from the first to the second generation.
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Estate Planning Strategy
¾ Most jurisdictions with estate or inheritance taxes allow decedents to make
bequests and gifts to their spouses without transfer tax liability.
¾ Valuation discounts can be employed to reduce the taxable value of gifts
or the estate. Liquidity discount and minority discount. The total discount is
subject to court approval and both tend to be inversely related to firm sizes.
Trusts
¾ In a revocable trust arrangement, the settlor (who originally transfers
assets to fund the trust) retains the right to rescind the trust relationship and
regain title to the trust assets.
¾ Irrevocable trust is a trust arrangement wherein the settlor has no ability to
revoke the trust relationship.
z An irrevocable trust structure generally provides greater asset protection
from claims against a settlor than a revocable trust.
¾ Fixed trust is a trust structure in which distributions to beneficiaries are
prescribed in the trust document to occur at certain times or in certain
amounts.
¾ Discretionary trust is a trust structure in which the trustee determines
whether and how much to distribute in the sole discretion of the trustee.
¾ Spendthrift trusts can be used to provide resources to beneficiaries who
may be unable or unwilling to manage the assets themselves, perhaps
because they are young, immature, or disabled.
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Life Insurance
Tax Jurisdiction
¾ Premiums paid on life insurance are not usually considered part of the
grantor’s estate for tax purposes, but are sometimes considered gifts to the
beneficiary.
¾ A country that taxes income as a source within its borders is said to impose
source jurisdiction, also referred to as a territorial tax system.
z This jurisdiction is derived from the relationship between the country
¾ From a tax perspective, life insurance is afforded beneficial tax treatment in
many jurisdictions. In addition, premiums paid by the policy holder are
typically neither part of the policy holder’s taxable estate at the time of his
or her death, nor subject to a gratuitous transfer tax.
¾ The use of life insurance in combination with a trust may be useful if the
ultimate beneficiaries (i.e., beneficiaries of the trust) are unable to manage
the assets themselves (e.g., in the case of minors, disabilities, or
spendthrifts).
and the source of the income;
z Countries imposing income tax exercise source jurisdiction.
¾ Countries may also impose tax based on residency, called residence
jurisdiction, whereby all income (domestic and foreign sourced) is subject
to taxation.
z In this case, the jurisdiction is derived from the relationship between the
country and the person receiving the income;
z Most countries use a residential tax system.
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Double Taxation
Relief from Double Taxation
¾ Residence–residence conflict means two countries may claim residence of
the same individual, subjecting the individual’s worldwide income to
taxation by both countries.
¾ Source–source conflict means two countries may claim source jurisdiction of
the same asset.
z Both countries may claim that the company income is derived from their
jurisdiction;
z For example, on income from a company situated in country A but
managed from country B. Both countries may claim that the company
income is derived from their jurisdiction.
¾ In a residence-source conflict an individual is subject to residence
jurisdiction and receives income on assets in a foreign country with source
jurisdiction.
z For example, a US citizen owning Singapore situated real estate would
be subject to US income tax and Singapore income tax on rental income
from the property.
¾ Residence-source conflicts are the most common source of double
taxation and the most difficult to avoid through tax planning without a
separate mechanism for relief that can mitigate or eliminate double taxation
through either foreign tax credit provisions or double taxation treaties.
¾ A source country is commonly viewed to have primary jurisdiction to tax
income within its borders, the residence country is typically expected to
provide double taxation relief.
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Foreign Tax Credit Provisions
¾ A residence country may choose to unilaterally provide its taxpayers relief
from residence-source conflicts within its own tax code: credit method,
exemption method, or deduction method.
¾ Under the credit method ,the residence country allows a tax credit for
taxes paid to a source country. (complete resolution)
z TCreditMethod = Max (TResidence, TSource)
¾ Under the exemption method, the country of residence charges no income
tax on income generated in a foreign country. (complete resolution)
z TExemptionMethod = TSource
¾ Under the deduction method ,the individual is only allowed to deduct the
amount of taxes paid to the source country. (partial resolution)
z TDeduction
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Method
= TResidence + TSource (1- TResidence) = TResidence + TSource -
TResidence TSource
Double Taxation Credit Provisions
¾ Boris Yankevich is a citizen and resident of Country A and has investments
in Country B. The tax rates on investment income and bequests for both
countries are listed below. Country A has a residence-based tax system and
Country B has a source jurisdiction on income generated within its borders.
Country A and Country B have a double tax treaty (DTT) to address this
residence-source conflict.
Country A (%)
Investment Income Tax
25
40
Estate Tax
50
30
¾ 1. What is Yankevich’s tax rate on investment income under the DTT if it
provides for the credit method? How much is remitted to Country A and
how much is remitted to Country B?
¾ 2. What is Yankevich’s tax rate on bequests under the DTT if it provides for
the exemption method?
¾ 3. What is Yankevich’s tax rate on bequests under the DTT if it provides for
the deduction method?
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Country B (%)
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Double Taxation Credit Provisions
¾ Correct Answer to 1:
Under the credit method, Tcreditmethod=Max[Tresidence, Tsource]. Therefore,
Tcreditmethod=Max[0.25, 0.40]=40%. In this case, 40% is remitted to
Country B. Nothing is remitted to Country A because it provides
Yankevich with a credit for his entire domestic tax liability.
¾ Correct Answer to 2:
Under the exemption method, the resident country relinquishes the
tax jurisdiction, so that the tax rate on bequests would be only 30%, all
of which is remitted to Country B.
¾ Correct Answer to 3:
Under the deduction method, Yankevich receives a home country tax
deduction (rather than a credit) for estate taxes paid to Country B. In
this case:
Tdeductionmethod=Tresidence+Tsource-TresidenceTsource
=0.50+0.30-(0.50 x 0.30)=0.65
Country A receives 35%, and Country B receives 30%.
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Double Taxation Treaties (DTT)
¾ In a addition to residence-source conflicts, DTTs resolve residence-residence
conflicts.
¾ DTTs typically do not resolve source-source conflicts.
¾ Tax avoidance is developing strategies that conform to both the spirit and
the letter of the tax codes of jurisdictions with taxing authority.
¾ Tax evasion, on the other hand, is the practice of circumventing tax
obligations by illegal means such as misreporting or not reporting relevant
information to tax authorities.
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It’s not the end but just beginning.
By training your thoughts to concentrate on the bright side of
Private
Wealth
Management
(2)
things, you are more likely to have the incentive to follow through on
your goals. You are less likely to be held back by negative ideas that
might limit your performance.
ડवઐীਘٜङ‫ױ߉۝ۃ‬ङ▲வरͫ଑߽҂‫ؼ‬ѫࡕՈ‫ؘ࣫‬ऩ߶ङԈ
ԃͫ৲Љѫ֜Оࢃߢࡘ䀀Ҡ࢟Љӹ澞
CFAЅঃ‫׀‬੟஍ࣹ
ઔ٤͹ஸ 朌
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Topic in CFA Level III
Session
Content
Study Session 1-2
ETHICS & PROFESSIONAL STANDARDS (1)&(2)
Study Session 3
THE ASSET MANAGEMENT INDUSTRY AND PROFESSIONALISM ǏNewǐ
Study Session 4
BEHAVIORAL FINANCE
Study Session 5-6
PRIVATE WEALTH MANAGEMENT (1)&(2)
Study Session 7
PORTFOLIO MANAGEMENT FOR INSTITUTIONAL INVESTORS
Study Session 8
APPLICATIONS OF ECONOMIC ANALYSIS TO PORTFOLIO MANAGEMENT
Study Session 9-10
ASSET ALLOCATION AND RELATED DECISIONS AND IN PORTFOLIO
MANAGEMENT (1)&(2)
¾ SS6: Private Wealth
management (2)
• R13 Concentrated Single-Asset
Positions
• R14 Risk Management for
Individuals
Framework
Private Wealth
Management (2)
Study Session 11-12 FIXED-INCOME PORTFOLIO MANAGEMENT (1)&(2)
Study Session 13-14 EQUITY PORTFOLIO MANAGEMENT (1)&(2) ǏNewǐ
Study Session 15
ALTERNATIVE INVESTMENTS FOR PORTFOLIO MANAGEMENT
Study Session 16
RISK MANAGEMENT
Study Session 17
RISK MANAGEMENT APPLICATIONS OF DERIVATIVES
Study Session 18
TRADING ǏNewǐ
Study Session 19
PERFORMANCE EVALUATION ǏNewǐ
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Framework
1. Risk in illiquid assets
2. Objectives in managing concentrated
positions
3. Tax and illiquidity
Reading
13
4. Capital market and institutional constraints
5. Psychological consideration
6. Goal-based decision process
7. Asset location and transfer
8. Techniques to manage concentrated
position
9. Managing concentrated stock position
Concentrated Single-Asset Positions
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10. Privately held business
11. Real estate positions
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Concentrated position
¾ Concentrated position
z A position that has been held by the private client for a long period,
sometimes for decades, and that has greatly appreciated in value over
its original cost (cost basis).
z Exposures to any of these risks may not be consistent with the
individual’s willingness and capacity to bear risk or may be suboptimal
with respect to asset allocation.
z Some concentrated positions may not be expected to earn fair riskadjusted returns.
Risk in concentrated position
¾ Systematic risk: risk that cannot be eliminated by holding a well-diversified
portfolio. The capital asset pricing model as practically implemented
equates systematic risk to equity market risk. More recently developed asset
pricing models identify multiple sources of systematic risk.
¾ Company-specific risk (non-systematic or idiosyncratic risk)
z Risks specific to a particular company’s operations, reputation, and
business environment, affecting a company but not the industry or
market as a whole.
z An extreme example of company-specific risk: a corporate bankruptcy;
z Increases volatility not expected return.
¾ Property-specific risk: risk specific to owning a particular piece of real
estate. The possibility that the value of that property might fall because of
an event that could affect that property but not the broader real estate
market.
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Objectives in managing concentrated positions
¾ Common objectives
z Appropriateness of risk reduction;
z Cash flow needs should be identified;
z Optimize tax efficiency: maximize after-tax return.
¾ Specific objectives and constraints
z Be mandated to hold shares for a long time period to motivate the
executive to work hard.
z The owner of a concentrated position might wish to maintain effective
voting control of the company.
z The owner of a concentrated position might wish to enhance the
current income of his or her stock position in the short term but in the
long term still retain significant upside potential with respect to the
stock.
z The property is an essential asset necessary for the successful
operation of a business enterprise.
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Tax and illiquidity
¾ Simply selling the asset outright will usually trigger an immediate and
sometimes significant taxable capital gain for the owner.
z Concentrated positions are often highly appreciated versus their original
cost.
¾ Concentrated positions are generally illiquid
z Owners of concentrated publicly traded stock positions may face
illiquidity.
9 If the trading volume of the company’s shares is small relative to the
size of the concentrated position;
9 If the shareholder is an insider and the timing or amount of any
sales is restricted by applicable securities laws and regulations.
z Determination of revenue of sale of his or her business
9 The strategy that is employed;
9 Who the buyer is.
z A buyer needs to be found for a particular property, and different
classes of potential buyers may place different values on that property.
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Capital market and institutional constraints
¾ The legal relationship that exists between the owners of a business
depends on the type of entity that is being used (e.g., sole trader,
partnership, limited partnership, or limited company, among other forms, in
the United Kingdom), the laws governing that type of entity, and any
documentation or agreements those laws require.
¾ Margin lending rules Margin rules determine how much a bank or
brokerage firm can lend against securities positions that their customers
own.
z Under a rule-based system, the amount that can be borrowed against a
security that the investor owns will depend on strict rules dealing with
the use of the loan proceeds.
z Portfolio margining is an example of a margin regime that is risk based.
¾ Company insiders and executives must often comply with a myriad of
rules and regulations promulgated by governmental authorities.
Capital market and institutional constraints
¾ Contractual restrictions and employer mandates
z Contractual restrictions
9 Such as initial public offering “lockups”.
z Employer mandates and policies
9 Such as a prohibition of trading during certain “blackout periods”
(i.e., periods when insiders cannot sell their shares)
z Can greatly restrict the flexibility of insiders and employees to either sell
or hedge their shares.
¾ Capital market limitations
z Certain characteristics of the underlying stock ultimately determine the
feasibility of hedging different concentrated positions and in what
degree they can be hedged.
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Psychological consideration
¾ Cognitive biases
Psychological consideration
¾ Emotional biases
z Conservatism (in the sense of reluctance to update beliefs);
z Overconfidence and familiarity (illusion of knowledge);
z Confirmation (looking for what confirms one’s beliefs);
z Status quo bias (preference for no change);
z Illusion of control (the tendency to overestimate one’s control over
events);
z Naïve extrapolation of past returns;
z Endowment effect (a tendency to ask for much more money to sell
z Anchoring and adjustment (the tendency to reach a decision by
making adjustments from an initial position, or “anchor”);
z Availability heuristic (the probability of events is influenced by the
ease with which examples of the event can be recalled).
something than one would be willing to pay to buy it);
z Loyalty effects.
¾ Comparing to emotional biases, cognitive biases are more easily to be
corrected.
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Goal-based decision process
¾ A goal-based methodology expands the traditional Markowitz framework
of diversifying market risk by incorporating several notional “risk buckets.”
¾ Risk buckets and sequence of priority
z First, personal risk bucket
9 Goal: protection from poverty or a dramatic decrease in lifestyle;
9 E.g. Allocate home (primary residence), certificates of deposit,
Treasury bills, and other “safe haven” investments;
9 Limit loss but yield below-market rates of return.
z Secondly, market risk bucket
9 Goal: maintain the current standard of living;
9 E.g. stock and bond portfolio.
Goal-based decision process
¾ Risk buckets and sequence of priority (cont.)
z Thirdly, aspirational risk bucket
9 Goal: opportunity to increase wealth substantially
9 E.g. concentrated positions, including privately owned businesses,
investment real estate, concentrated stock positions, stock options,
and the like.
¾ Implement a goal-based plan
z Primary capital: whether the proceeds, when combined with the assets
the owner already has outside the concentrated position, are at least
sufficient to provide for the owner’s lifetime spending needs.
z Surplus capital: the sale or monetization will generate even more than
the primary capital requirement.
z Discuss with the client whether the sale or monetization of the
concentrated position can achieve financial independence for the owner.
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Asset location and transfer
¾ Asset location (distinct from the asset allocation decision.) determines
the method of taxation that will apply. What type of account an asset is held
within. Location in a tax-deferred account would defer all taxes to a future
date.
Asset location and transfer
¾ Wealth transfer: estate planning or gifts.
z Advisers who are able to work with clients before the concentrated
position has appreciated greatly in value can have the most impact. No
limitation of transferring wealth if there are no unrealized gains.
z Interest income, dividends and long-term capital gains are all taxed
differently in a taxable account.
z Donation to charity is free from taxes.
z An estate tax freeze: transfer future appreciation to the next
generation at little or no gift or estate tax cost.
9 One class is voting preferred;
9 The other is non-voting common. The non-voting common stock is
gifted to the next generation.
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Techniques to manage concentrated position
Managing concentrated stock position
¾ Outright sale: Owners can sell the concentrated position, which gives them
funds to spend or reinvest but often incurs significant tax liabilities.
¾ Monetization strategies: These provide owners with funds to spend or reinvest without triggering a taxable event. A loan against the value of a
concentrated position is an example of a simple monetization strategy.
¾ Hedging the value of the concentrated asset: Derivatives are frequently
used in such transactions.
¾ Equity monetization generally refers to the transformation of a
Derivatives used in hedging
OTC
• Trade with counterparty
(default risk)
• Flexible choices
¾ Two-step process
z Step 1: Remove a large portion of the risk inherent in the concentrated
position.
9 The process of hedging the concentrated stock position could be
fraught with complex tax regulations. Care should be taken in
Exchange-traded
• Standardized
concentrated position into cash.
liquidity
• Function of discover price
• Higher fees concerning transparency
and transactions
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structuring the hedge such that the economic incentives (as well as
disincentives) of holding the concentrated stock position are not
eliminated.
z Step 2: borrow against the hedged position.
9 A high loan-to-value (LTV) ratio can be achieved because the stock
position is hedged.
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Managing concentrated stock position
¾ Four techniques of managing concentrated stock position
¾ Assume an investor owns 1 million shares of ABC Corp. stock and ABC Corp.
shares are currently trading at $100 per share, so the investor is long $100
million of ABC Corp. shares. To establish an exactly offsetting short
position in ABC Corp. shares, the investor could use any of the four
techniques mentioned above and described below.
z A short sale against the box: shorting a security that is held long;
9 The investor could borrow 1 million shares of ABC Corp. stock from
a broker/dealer and then sell those shares in the marketplace, thus
establishing a $100 million short position in ABC Corp. stock.
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Managing concentrated stock position
¾ Four techniques (cont.)
z A total return equity swap: a contract for a series of exchanges of the
total return on a specified asset in return for specified fixed or floating
payments;
9 The investor and a derivative dealer could agree to an exchange of
cash flows based on a $100 million notional amount of ABC Corp.
shares.
z Options (forward conversion): the construction of a synthetic short
forward position against the asset held long;
9 The investor could buy ABC Corp. puts and sell ABC Corp. calls with
the same strike price (i.e., $100) and the same termination date
covering 1 million shares
z A forward sale contract/single-stock futures contract: a private
contract for the forward sale of an equity position.
9 The investor could agree today to sell her ABC shares to a dealer
three years from now.
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Managing concentrated stock position
¾ If the tax authorities of a country respect legal form over economic
substance, equity monetization techniques should not trigger an
immediate taxable event for unrealized gains.
¾ Lock in unrealized gains: hedging
z Purchase of puts: Investors holding a concentrated position can
purchase put options to
9 Lock in a floor price;
9 Retain unlimited upside potential;
9 Defer the capital gains tax.
9 Methods
‹ Protective puts;
‹ A pair of puts: Long a put at a higher strike price of XH and
short a put at a lower strike price of XL.
‹ Knock-out put: the protection “knocks out” or disappears
before its stated expiration if the stock price increases to a
certain level.
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Managing concentrated stock position
¾ Lock in unrealized gains: hedging (cont.)
z Cashless (zero-premium) collars:
9 Hedge against a decline in the price of a stock;
9 Retain a certain degree of upside potential with respect to the stock;
9 Defer the capital gains tax while avoiding any out-of-pocket
expenditure.
z Prepaid variable forwards (PVF): A collar hedges the value of the
concentrated position.
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Managing concentrated stock position
¾ Lock in unrealized gains: hedging (cont.)
z Choosing the best hedging strategy: The tax characteristics of the
shares or other instrument that is being hedged can help determine
which strategy will deliver the optimal result for the client.
z Mismatch in character: potential tax inefficiency that can result if the
instrument being hedged and the tool that is being used to hedge it
produce income and loss of a different character.
9 For example, a collar established by long put and short call. The
option premium received now from call is taxed at 25% versus a
future reduction in long-term gain that would be taxed at 15%.
9 Tax attributes and characteristics of the shares or other instrument
that is being hedged can influence the decisions as to
‹ What hedging tool should be used;
‹ How the transaction should be documented.
Managing concentrated stock position
¾ Yield enhancement: write covered calls and earn premium as
z Yield enhancement;
z Hedge from decline in stock price.
¾ Other tools: Tax-optimization equity strategies
z Index tracking with active tax management: Funded by cash (from a
partial sale of the investor’s concentrated stock position or/and the
monetization proceeds derived from the hedged stock position) to track
a broad-based market on a pre-tax basis and outperform it on an aftertax basis with strategies use opportunistic capital loss harvesting and
gain deferral techniques.
9 E.g. If tax of dividends > capital gains, choose stocks with lower
dividend yield and higher price appreciation.
z A completeness portfolio: The combination of the concentrated
portfolio and newly added stocks tracks the broadly diversified market
benchmark.
9 E.g. concentrated position in auto stock + other stocks with low
correlation of auto stocks.
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Managing concentrated stock position
¾ Cross hedge
Privately held business
¾ Characteristic of privately held businesses
z Short a security or basket of securities that have the highest
correlation with the investor’s concentrated stock position.
z Short a broad or targeted index that is investable to serve as the
substitute asset. The investor is at least able to hedge market and
z Considerable concentration risk;
z High company specific risks;
z Illiquidity.
¾ Exit strategies
industry risk. However, the investor retains all of the company-specific
z Valuation level of target companies;
risk of the concentrated position.
z Tax rate applicable to a particular exit strategy;
z Purchasing puts on the proxy asset
¾ An exchange fund is an investment fund structured as a partnership in
which the partners have each contributed their low-basis concentrated stock
positions to the fund. Each partner then owns a pro rata interest in the
partnership. (not taxable event; minimum 7 years)
z Condition of the credit markets;
z Level of interest rates;
z Amount of buying power in the marketplace (strategic and financial
buyers);
z Currency valuation.
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Privately held business
¾ Strategies in managing a private business equity
z Strategic buyers: Most strategic buyers tend to take a long-term view
of their investments in other companies. Because of this fact, they will
typically pay the highest price for a business because of potential
revenue, cost, and other potential synergies.
z Private equity firms (financial buyers/ financial sponsors) make direct
investments in mature and stable middle-market businesses and target
earning a high internal rate of return over a fairly short period of time
(3-5 years).
z Recapitalization (attractive to middle-market business)
9 The owner transfers a portion of her stock (60%-80%) for cash and
retains a minority ownership interest (20%-40%) in the freshly
capitalized entity. Because of the retained stake, the owner should
Privately held business
¾ Strategies in managing a private business equity
z Sale to (other) management or key employees, disadvantages:
9 Cannot raise sufficient funds to make a serious cash offer.
9 Finance a substantial amount of the purchase price in the form of a
promissory note.
‹The promissory note contingent on the financial performance
of the company with considerable risk of unknown
entrepreneurial capabilities.
9 A failed attempt to do an MBO (management buyout) has the
potential to negatively affect the dynamics of the employer–
employee relationship.
remain highly motivated to grow the business.
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Privately held business
¾ Strategies in managing a private business equity
z Divestiture (sale, or disposition of non-core business assets): If a
business owner is not yet ready to retire and wishes to continue to run
the business but would like to generate some liquidity now in order to
diversify, she/he may consider selling a certain line of business or
closing a division.
z Sale or gift to family members: Implement through a combination of
tax- advantaged gifting strategies, to a family member or members who
are typically actively involved in the business. Existing disadvantages:
9 Family members may not have the necessary capital to buy the
business. (Same problem as MBO)
9 Unless the owner has accumulated sufficient investable assets
Privately held business
¾ Strategies in managing a private business equity
z Personal line of credit secured by company shares: The owner might
consider arranging a personal loan secured by his or her shares in the
private company. This strategy will not cause an immediate taxable
event to the company or the owner if structured properly.
z Initial public offering (IPO): An IPO should be viewed as a financing
tool that can be used to grow and take the company to a new level,
assuming the owner wishes to remain actively involved in the company
at least for the foreseeable future.
z Employee stock ownership plan (ESOP): Sell some or all of his or her
company shares to certain types of pension plans. In a leveraged ESOP,
outside the business to sustain his or her desired lifestyle without
if the company has borrowing capacity, the ESOP borrows funds
regard to the business, gifting might not be feasible.
(typically from a bank) to finance the purchase of the owner’s shares.
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Real estate positions
Real estate positions
¾ Real estate owners are often exposed to a significant degree of
concentration risk and illiquidity.
¾ Factors determine the attractiveness of the market from the seller’s
perspective
z Current valuation of real estate relative to historical levels and future
expectations;
¾ Monetization strategies for real estate owners
z Mortgage financing is used to lower concentration in a particular
property and generate liquidity to diversify asset portfolios without
triggering a taxable event. With a non-recourse loan (meaning that the
lender’s only recourse upon an event of default is the property that was
mortgaged to the lender), the investor has economically acquired the
equivalent of a put issued by the lender.
z Tax rate applicable to a particular property and transaction;
z Condition of the credit markets and lending conditions;
z Level of interest rates.
z Charitably inclined: tax advantages created by donor-advised fund
(DAF) , tax-exempt charitable trust.
z Sale and leaseback: The owner of a property sells that property and
then immediately leases it back from the buyer. The primary goal of a
sale and leaseback is to raise capital or free up the owner’s equity (that
is invested in the property) for other uses while retaining use of the
facility. Rental payments for the lease can be deducted before taxed.
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Framework
Reading
14
1. Human Capital and Financial Capital
2. The Risk Management Strategy for
Individuals
3. The Financial Stages of Life for an
Individual
4. The Individual Balance Sheet
5. Individual Risk Exposures
6. Life Insurance
7. Annuities
Risk Management for Individuals
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8. Implementation of Risk Management
(Individual)
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Human capital and financial capital
¾ Human capital. future wages or earnings can be thought of as analogous
(in a rough sense) to future interest or dividend payments that flow from an
individual’s work-related skills, knowledge, experience, and other productive
attributes that can be converted into wage income.
¾ Financial capital can be subdivided into various components besides
tangible and intangible, such as current assets, personal assets and
investment assets.
Financial capital
¾ An individual’s assets can be described as “personal” assets or
“investment” assets.
z Personal assets are consumed. Automobile, clothes, furniture and even
a personal residence. Real estate and collectibles could be considered a
“mixed” asset.
z Investment assets are held for their potential to increase in value and
fund future consumption.
9 Marketable
‹ Publicly traded marketable assets;
‹ Non-publicly traded marketable assets: real estate, some types
of annuities, cash-value life insurance, business assets, and
collectibles.
9 Non-marketable assets
‹ Employer pension plans (vested);
‹ Government pensions.
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Financial stages of life for an individual
¾ The financial stages of life for an individual
z Education phase: The education phase occurs while an individual is
investing in knowledge (or human capital) through either formal
education or skill development.
z Early career: The early career phase normally begins when an individual
has completed his or her education and enters the workforce.
z Career development: The career development phase normally occurs
during the 35–50 age range and is often a time of specific skill
development within a given field, upward career mobility, and income
growth.
z Peak accumulation: In the peak accumulation phase, generally during
the ages of 51–60, most people either have reached or are moving
toward maximum earnings and have the greatest opportunity for wealth
Financial stages of life for an individual
¾ The financial stages of life for an individual
z Pre-retirement: The pre-retirement phase consists of the few years
preceding the planned retirement age, and it typically represents an
individual’s maximum career income.
z Early retirement: The early retirement phase in the cycle is generally
defined as the first 10 years of retirement and, for successful investors,
often represents a period of comfortable income and sufficient assets to
meet expenses.
z Late retirement: The late retirement phase is especially unpredictable
because the exact length of retirement is unknown. Longevity risk and
cognitive decline.
accumulation.
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Net worth
Individual balance sheet
¾ An individual’s net worth consists of the difference between traditional
assets and liabilities that are reasonably simple to measure, such as
investment assets, real estate, and mortgages.
¾ Net wealth extends net worth to include claims to future assets that can be
used for consumption, such as human capital and the present value of
pension benefits.
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¾ Traditional balance sheet includes A/L that are easy to quantify.
Assets
Liquid Assets
Checking account
Certificates of deposit
Total liquid assets
Investment Assets
Taxable account
Retirement plan
Cash value of life insurance
Total investment assets
Personal Property
House
Cars
House contents
Total personal property
Total Assets
Liabilities
Short-Term Liabilities
€ 35,000 Credit card debt
€ 100,000 Total short-term liabilities
€ 135,000
Long-Term Liabilities
€ 750,000 Car loan*
€ 600,000 Home mortgage
€ 25,000 Home equity loan
€ 1,375,000 Total long-term liabilities
€ 2,200,000
€ 160,000
€ 150,000
€ 2,510,000
€ 4,020,000 Liability
Net worth
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€ 25,000
€ 25,000
€ 25,000
€ 500,000
€ 90,000
€ 615,000
€ 640,000
€ 3,380,000
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Individual balance sheet
Risk management strategy for individuals
¾ Economic (holistic) balance sheet allows an individual to anticipate how
available resources can be used to fund consumption over the remaining
lifetime. discuss risks (earnings, premature death, longevity, property,
liability, and health risks) in relation to human and financial capital.
Assets
Financial capital
Liquid assets
Investment assets
Personal property
Liabilities
€ 4,020,000 Debts
Credit card debt
Car loan
Home mortgage
Home equity loan
€ 1,400,000 Lifetime consumption
needs (present value)
€ 500,000
Bequests
€ 5,920,000 Total Liabilities
Net Wealth
Human capital
Pension value
Total Assets
€ 640,000
¾ Risk management for individuals is the process of identifying threats to
the value of household assets and developing an appropriate strategy for
dealing with these risks.
¾ There are typically four key steps in the risk management process
z Specify the objective.
z Identify risks.
z Evaluate risks and select appropriate methods to manage the risks.
9 Risk avoidance;
€ 4,200,000
€ 400,000
€ 5,240,000
€ 680,000
9 Risk reduction;
9 Risk transfer (insurance);
9 Risk retention (self-insurance).
z Monitor outcomes and risk exposures and make appropriate
adjustments in methods.
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Implementation of risk management
¾ For individual
z The decision to retain risk or to manage risk through insurance or
annuities is determined by a household’s risk tolerance.
z Optimal risk management strategies are as follows.
Risk Management Techniques
Loss characteristics
High frequency
Low frequency
High severity
Risk avoidance
Risk transfer
Low severity
Risk reduction
Risk retention
Individual risk exposures
¾ Risk exposures
z Earnings risk (insure with disability insurance): the risks associated
with the earning potential of an individual—that is, events that could
negatively affect the individual’s human and financial capital.
z Premature death risk (insure with life insurance): the risk of the
death of an individual earlier than anticipated whose future earnings, or
human capital, were expected to help pay for financial needs and
aspirations of the individual’s family.
z Longevity risk (insure with annuities): the uncertainty surrounding
how long retirement will last and specifically the risks associated with
living to an advanced age in retirement (e.g., age 100).
z Property risk (insure with property insurance): the possibility that a
person’s property may be damaged, destroyed, stolen, or lost.
z Liability risk (insure with liability insurance): the possibility that an
individual or household may be held legally liable for the financial costs
associated with property damage or physical injury.
z Health risk (insure with health insurance): the risk and implications
associated with illness or injury.
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Life insurance
Permanent life insurance
¾ Life insurance protects against the loss of human capital for those who
depend on an individual’s future earnings.
¾ Use of life insurance
z A hedge against the risk of the premature death of an earner;
z An important estate-planning tool;
z A tax-sheltered savings instrument.
¾ Types of life insurance
z Temporary life insurance provides insurance for a certain period of
time specified at purchase (term life insurance);
z Permanent life insurance provides lifetime coverage, assuming the
premiums are paid over the entire period.
9 Whole life insurance remains in force for an insured’s entire life;
9 Universal life insurance is constructed to provide more flexibility
than whole life insurance.
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¾ Whole life insurance remains in force for an insured’s entire life and
requires regular, ongoing fixed premiums.
z Can be divided into two subgroups
9 Participating life insurance policies allow potential growth at a
higher rate than the guaranteed value, based on the profits of the
insurance company.
9 A non-participating policy is one with fixed values: The benefits
will not change based on the profits and experience of the insurance
company.
¾ Universal life insurance is constructed to provide more flexibility
than whole life insurance.
z The policy owner, generally the insured, has the ability to pay higher or
lower premium payments and often has more options for investing the
cash value. The insurance will stay in force as long as the premiums paid
or the cash value is enough to cover the policy expenses of the provider.
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Life insurance
Life insurance
¾ The basic elements of a life insurance policy
z The term and type of the policy (e.g., A 20-year temporary insurance
policy);
z The amount of benefits (e.g., £100,000);
z Limitations under which the death benefit could be withheld (e.g., If
¾ The basic elements of a life insurance policy
z Elimination/waiting period
z Non-forfeiture clause: ЉЖ‫୐࣫ע‬џқ
z Guaranteed insurability
death is by suicide within two years of issuance);
z The contestability period (the period during which the insurance
company can investigate and deny claims);
z The identity (name, age, gender) of the insured;
z The policy owner (generally needs to have an insurable interest in the
life of the insured);
z The beneficiary or beneficiaries;
z The premium schedule (the amount and frequency of premiums due);
z Modifications to coverage (ґௌ) in any riders to the policy.
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Cash value and policy reserves
¾ Three key considerations in the pricing of life insurance
z Mortality expectations: Actuaries at insurance companies estimate
mortality based on both historical data and future mortality
expectations. Generally speaking, life expectancies in most regions of
the world have been increasing. Certain attributes, such as age and
gender, are obvious factors in evaluating life expectancy. To avoid
adverse selection and undercharging for the risk assumed.
z The net premium of a life insurance policy represents the discounted
value of the future death benefit.
9 A probability of 0.15% of dying within the year, death benefit
$100,000, discount rate 5.5%. Net premium = (0.15%*$100,000 +
99.85% * $0)/1.055= $142.18
z The gross premium adds a load to the net premium, allowing for
expenses and a projected profit for the insurance company.
¾ Although initial premiums are higher,
whole life policies offer the
advantage of level premiums and an
accumulation of cash value within the
policy that
z Can be withdrawn by the policy
owner when the policy endows
(or matures) or when he or she
terminates the policy;
z Can be borrowed as a loan while
keeping the policy in force.
¾ These cash values build up very
Policy face
value
slowly in the early years, during
which the company is making up for
its expenses.
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Build-up of cash value in a whole
life insurance policy
CASH VALUE
Life insurance
Insurance value
Age at Issue
Cash value
AGE
Age at
Endowment
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Annuities
Annuities
¾ Deferred variable annuities: In its most basic form, a deferred variable
annuity is similar to a mutual fund, although it is structured as an insurance
contract and typically sold by someone licensed to sell insurance products.
¾ Deferred fixed annuities: Deferred fixed annuities provide an annuity
payout that begins at some future date.
¾ Immediate variable annuities: With an immediate variable annuity, the
individual permanently exchanges a lump sum for an annuity contract that
promises to pay the annuitant an income for life.
¾ Immediate fixed annuities: The most common and the most utilized type
of annuity, an individual trades a sum of money today for a promised
income benefit for as long as he or she is alive.
¾ Advanced life deferred annuities: The final type of annuity that we discuss
is a hybrid of a deferred fixed annuity and an immediate fixed annuity. An
ALDA’s payments begin later in life, for example, when the individual turns
80 or 85. pure longevity insurance.
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Annuities
Annuities
¾ Relative advantages and disadvantages of fixed and variable annuities
z Volatility of benefit amount: Fixed annuities provide a constant income
stream that is guaranteed not to change, whereas the income from a
variable annuity could change considerably depending on the terms of the
annuity payout.
z Flexibility: The flexibility of an annuity varies materially with the type
of annuity and its individual features.
z Future market expectations: A fixed annuity locks the annuitant into a
portfolio of bond-like assets at whatever rate of return exists at the time of
purchase. This scenario creates some interest rate risk because the value of
these underlying securities will fall if interest rates rise.
9 Mortality credits: Some individuals will die before, and some after,
their expected lifespan. Annuitants who die earlier collect fewer
payouts, effectively subsidizing those who die later. That is why
insurance is called risk sharing or transfer.
¾ Relative advantages and disadvantages of fixed and variable annuities
z Inflation concerns: Inflation can have a significant negative impact on
the real income received from a fixed annuity. For example, if annual
inflation averages 3%, after approximately 24 years, the income would
be worth approximately half as much as it was worth when the annuity
began.
z Payout methods: The payout methods available from an annuity are
similar regardless of whether the annuity is fixed or variable, including
joint life, period-certain annuity, and life annuity with period certain (े
ґ߂‫ٶص‬ѡ‫)ރ‬.
z Annuity benefit taxation: In some locations, annuities can offer
attractive tax benefits, such as tax-deferred growth.
z Appropriateness of annuities: The individual can choose either to
receive periodic withdrawals from an investment portfolio (i.e., not
annuitize) or to purchase an annuity (i.e., annuitize).
z Fees: The fees associated with variable annuities tend to be higher than
those for fixed annuities (the costs of hedging market risk,
administrative expenses, and reduced price competition).
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Other types of insurance
¾ Disability income insurance is designed to mitigate earnings risk as a
result of a disability, which refers to the risk that an individual becomes less
than fully employed because of a physical injury, disease, or other
impairment.
z Waiver of premium͹܎ґыҲ儋ґகો
¾ Property insurance is used by individuals to manage property risk . The
primary areas to cover are the home/ residence and the automobile.
¾ Health/Medical Insurance is highly dependent on the country of residence.
In certain countries, health care is governmentally funded and there is no
private health insurance. In others, there is a two-tiered system, with
governmental coverage for everyone and upgraded coverage for additional
payments.
Implementation of risk management
¾ For individual
z The effect of human capital on asset allocation policy
9 For equity-like human capitals: less aggressive portfolio;
9 For bond-like human capitals: more aggressive portfolio;
9 For younger: more equities;
9 For older: more bonds.
z The risk faced with the individuals can be classified as
9 Idiosyncratic risks include the risks of a specific occupation, the risk
of living a very long life or experiencing a long-term illness, and the
risk of premature death or loss of property;
9 Systematic risks affect all households. For example, a diversified
investment portfolio of risky assets will be exposed to the
systematic risk that the overall market will fall in value.
¾ Liability insurance is used to manage liability risk.
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It’s not the end but just beginning.
Your life can be enhanced, and your happiness enriched, when you choose
to change your perspective. Don't leave your future to chance, or wait for things
to get better mysteriously on their own. You must go in the direction of your
hopes and aspirations. Begin to build your confidence, and work through
problems rather than avoid them. Remember that power is not necessarily
control over situations, but the ability to deal with whatever comes your way.
▲‫ޚ‬Պ݅र୼ொङઅ‫ͫچ‬҂ङࣿࡴѫ崼ࣀ‫ٸͫ߇ڐ‬क़‫ڽ‬Щѫ‫ݎ‬廼৲ߛ澞Ӱс
ӟ‫ݗ݋‬ո଍ङПԈߓͫЭӰܶ߈‫ق‬வѫЉՕ‫ۃ‬ઑङ‫૴ױ‬澞҂‫ீڷ‬Њӄ‫ڶ‬٥߈Њࢽ
‫࠵ە‬લ▲ਚ澞‫ॹڏ‬ਘҒͫ‫ހ‬йЊ֟஡िҾब‫ͫݎ‬৲ள৉ଳ৲੧澞ઓѻͫԃ୏Љީ
Alternative
Investments
for Portfolio
Management
CFAЅঃ‫׀‬੟஍ࣹ
௟橆‫ق‬Ԏङࡣ‫ֳޗͫؗ‬Љ‫ݥ‬ङਈԃ۵ީ߂୍੽ङ澞
ઔ٤͹ஸ朌
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Topic in CFA Level III
Session
Content
Study Session 1-2
ETHICS & PROFESSIONAL STANDARDS (1)&(2)
Study Session 3
THE ASSET MANAGEMENT INDUSTRY AND PROFESSIONALISM ǏNewǐ
Study Session 4
BEHAVIORAL FINANCE
Study Session 5-6
PRIVATE WEALTH MANAGEMENT (1)&(2)
Study Session 7
PORTFOLIO MANAGEMENT FOR INSTITUTIONAL INVESTORS
Study Session 8
APPLICATIONS OF ECONOMIC ANALYSIS TO PORTFOLIO MANAGEMENT
Study Session 9-10
ASSET ALLOCATION AND RELATED DECISIONS AND IN PORTFOLIO
MANAGEMENT (1)&(2)
Framework
¾ SS15: Alternative Investments
Alternative Investments
for Portfolio Management
for Portfolio Management
• R30 Alternative Investments
Portfolio Management
Study Session 11-12 FIXED-INCOME PORTFOLIO MANAGEMENT (1)&(2)
Study Session 13-14 EQUITY PORTFOLIO MANAGEMENT (1)&(2) ǏNewǐ
Study Session 15
ALTERNATIVE INVESTMENTS FOR PORTFOLIO MANAGEMENT
Study Session 16
RISK MANAGEMENT
Study Session 17
RISK MANAGEMENT APPLICATIONS OF DERIVATIVES
Study Session 18
TRADING ǏNewǐ
Study Session 19
PERFORMANCE EVALUATION ǏNewǐ
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Alternative investment groups
¾ Reasons for investing in alternative investments
z Risk diversification;
z Active management;
Reading
30
z Capture alpha.
¾ Types of alternative investment
z Real estate;
z Private equity/venture capital;
z Commodities;
z Hedge fund;
Alternative Investments Portfolio Management
z Managed futures;
z Distressed securities.
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Common features of alternative investments
¾ Common features of alternative investments
z Relative illiquidity;
z Diversifying potential relative to a portfolio of stocks and bonds;
z High due diligence costs;
z Difficult performance appraisal because of complexity of establishing
valid benchmark;
z Informationally less efficient than the world’s major equity and bond
markets.
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General due diligence checkpoints
¾ Chief points of active manager selection process
z Market opportunity.
9 What is the opportunity, and why is it there?
z Investment process.
9 Who does this best, and what is their edge?
z Organization.
9 Are all the pieces in place?
z People.
9 Do we trust the people?
z Terms and structure.
9 Are the terms fair? Are interests aligned?
z Service providers.
9 Who supports them?
z Documents.
9 Read the documents!
z Write-up.
9 Ensures organized thought, informs others, and formally documents
the process.
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Issues for private wealth clients
¾ Questions for advisors of private wealth clients
z Tax issues (pervasive for individuals);
z Determining suitability (time horizon, liquidity needs, emotional
and financial needs);
z Communication with clients (e.g. discuss the suitability);
z Decision risk, the risk of changing strategies at the point of
maximum loss. Decision risk is increased by strategies that by their
nature have
9 Frequent small positive returns but, when a large return occurs,
it is more likely to be a large negative return than a large
positive one;
9 Extreme returns (relative the mean return) with some unusual
degree of frequency.
z Concentrated equity position, e.g. substantial part of wealth in
closely held companies or private residences.
Topics in detailed alternative investments
¾ We will cover the following aspects for all types of alternative
investments
z Types of investments;
z Benchmarks;
z Historical performance and interpretations;
z Investment characteristics;
z Roles in portfolios;
z Other issues.
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Real estate
Real estate
¾ Types of investments
z Our discussion is focused on equity investments in real estate,
mortgages, securitizations of mortgages, hybrid debt/equity interests
are not covered;
z Direct ownership
9 Investment in residences, business (commercial) real estate, and
agricultural land;
z Indirect investments (“financial ownership”)
9 Companies engaged in real estate ownership, development, or
management;
9 REITs, which are publicly traded equities representing pools of
money invested in real estate properties and/or real estate debt;
9 CREFs (commingled real estate funds), which are professionally
managed vehicles for substantial commingled (i.e., pooled )
investment in real estate properties;
9 Separately managed accounts, which are often offered by the
same real estate advisors sponsoring CREFs.
¾ Indirect investments (cont’d)
z Infrastructure funds, which in cooperation with governmental
authorities, make private investment in public infrastructure projects –
such as roads, tunnels, schools, hospitals, and airports - in return for
rights to specified revenue streams over a contracted period.
9 A private company or a consortium of private companies maintains
the physical infrastructure over a period that often ranges from 25
to 30 years;
9 The public sector (via the government) leases the infrastructure and
pays the consortium an annual fee for the use of the completed
project over the contracted period;
9 The projects are financed through bond issuance by the consortium
as well as by an equity investment. The consortium will often want
to pull its equity capital out of a project for reinvestment in other
projects;
9 The public sector avoids the need to issue debt or raise taxes to
finance infrastructure and ensures safety.
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Real estate
Real estate
¾ Investment characteristics
z Real estate is an asset in itself with some intrinsic value based on the
benefits it may supply to individuals or business;
z Investment in commercial real estate properties includes a substantial
income component through rental income;
z The physical real estate market is characterized by relative lack of
liquidity, large lot sizes, relatively high transaction costs,
heterogeneity, immobility, and relative low information
transparency;
z The lack of reliable, high-frequency transaction data for properties
necessitates the use of appraisal-based valuations;
z Various market and economic factors affect demand and supply for
real estate: Interest rate, business financing costs, employment levels,
saving habits, demand and supply for mortgage financing;
z Mixed conclusions on the inflation-hedging capabilities of real estate
investment;
z Values are affected by idiosyncratic variables, such as location.
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¾ Investment characteristics (cont’d) – general advantages and
disadvantages of direct equity investments in real estate investing.
z Advantages
9 The law allows mortgage interest, property taxes, and other
expenses to be tax deductible;
9 Mortgage loans permit most real estate borrowers to use more
financial leverage than is available in most securities investing;
9 Direct real estate investors have direct control over their property
and may take action to increase the market value of the property;
9 Geographical diversification can be effective in reducing exposure
to catastrophic risks;
9 Relatively lower volatility than public equities.
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Real estate
Real estate
¾ Investment characteristics (cont’d) – general advantages and
disadvantages of direct equity investments in real estate investing.
z Disadvantages
9 Most parcels of real estate are not easy to divide into smaller
pieces. As a result, when such properties are a relatively large part if
a investor’s total portfolio, real estate investing may involve large
idiosyncratic risks for investors;
9 The cost of acquiring information is high;
9 Real estate brokers charge high commissions;
9 Real estate involves substantial operating and maintenance costs
and hands-on management expertise;
9 Investors are exposed to the risk of neighborhood deterioration;
9 Any income tax deductions that a taxable investor in real estate may
benefit from are subject to political risk- they may be discontinued.
¾ Benchmarks of real estate
z Benchmarks
9 NCREIF;
9 NAREIT.
z Construction
9 NCREIF is value weighted and includes sub-indices grouped by real
estate sector and geographical region.
9 NAREIT is a real-time, market-cap-weighted index of al REITs actively
traded on the New York Stock Exchange and American Stock
Exchange.
z Biases
9 The tendency to underestimate volatility in underlying values;
9 Property appraisals are also conducted infrequently (typically once a
year).
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Private equity
Historical performance – real estate
¾ Real estate performance in portfolios, 1996-2015.(including REITs)
Portfolios
A
B
C
D
Annualized Return
7.26%
7.70%
7.26%
7.69%
Standard Deviation
7.83%
8.36%
8.11%
8.62%
0.93
0.92
0.89
0.89
-27.11%
-31.34
-31.11%
-34.77%
Mean Return-to-Volatility Ratio
Maximum Drawdown
Correlation With Real Estate
0.60
0.61
Portfolio A
Equal weights S&P 500 and Bloomberg Barclays US aggregate.
Portfolio B
90% Portfolio A and 10% real estate.
Portfolio C
75% Portfolio A and 25% managed futures/commodities/private
equity/hedge funds.
Portfolio D
90% Portfolio C and 10% real estate.
¾ Definition: the term “private equity” refers to any security by which equity
capital is raised via a private placement rather than through a public
offerings. Private equity securities are not registered with a regulatory body;
¾ Private equity investments can be made face-to-face (direct) with the
company needing financing or indirectly through private equity funds;
¾ Private equity fund: The pooled investment vehicles through which many
investors make (indirect) investments in generally illiquid assets. These
activities include financing private businesses, leveraged buyouts of public
companies, distressed debt investing, public financing of public
infrastructure projects, etc;
¾ Major investors in private equity funds: public pension funds (largest
players by $ committed), endowments and foundations (largest
allocations in policy portfolios), and family offices;
¾ Our discussion is on the two historically most important fields of private
equity – venture capital and buyout funds;
¾ In venture capital, a company starts out as private eventually become
publicly owned; the converse process – taking a publicly owned company
private constitutes the chief sphere in buyout funds.
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Private equity
Private equity
¾ Differences between public and private equity investments.
¾ Exhibit: Investment process of (direct) private equity investment and
¾ Investment process of (direct) private equity investment and investment
in publicly traded equities.
investment in publicly traded equities.
Private Equity Investments
Publicly Traded Securities
Structure and Valuation
Deal structure and price are
negotiated between the investor and
company management.
Price is set in the context of the market.
Deal structure is standardized.
Variations typically require approval
form securities regulators.
Private Equity Investments
Publicly Traded Securities
Post Investment Activity
Investors typically remain heavily
involved in the company after the
transaction by participating at the
board level and through regular
contact with management.
Investors typically do not sit on
corporate boards or make ongoing
assessment based on publicly available
information and have limited access to
management.
Access to Information for Investment Selection
Investor can request access to all
information, including internal
projections.
Analysts can use only publicly available
information to assess investment
potential.
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Private equity / venture capital
Private equity / venture capital
¾ Stages & investors of venture capital
zStages: Formative-stage, expansion stage;
zInvestors: Angel investors, venture capitalists, corporate venturing.
¾ Demand for venture capital and venture capital timeline.
Formative Stage Companies
Stage
Characteristics
Stage
Financing
Second
Stage
Expansion Stage Companies
Early Stage
Seed
Pre-IPO
Third
Stage
Mezzanine
Moving into
operation,
initial revenues.
Revenue growth.
Preparation
for IPO.
Angels, VC.
VC, strategic
partners.
Seed
Idea
incorporation,
first people
hired,
prototype
development.
Founders,
angels, VC.
Later Stage
First
Stage
Formative Stage Companies
Expansion Stage Companies
Early Stage
Start
Up
¾ Demand for venture capital and venture capital timeline.
Purpose
of
Financing
Support
market
research
and
establish
business.
Start-Up
Start-up financing
supports product
development and
initial marketing.
First-stage financing
supports initial
manufacturing and
sales.
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Later Stage
First
Stage
Second
Stage
Third
Stage
Pre-IPO
Mezzanine
Second-stage
financing
supports initial
expansion of a
company.
Third-stage financing
provides capital for
major expansion.
Provides
capital to
prepare
for IPO—
often a
mix of
debt and
equity.
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Private equity / venture capital
¾ Supply for venture capital
z Angel investors are accredited individual investing chiefly in seed and
early-stage companies, sometimes after the resources of the founder’s
friends and family have been exhausted.
9 Angel investors are often the first outside investors in a company,
even before a company is organized or there is a real product;
9 The size of investments made by angels is relatively small. However
such investments are among the riskiest.
Private equity / venture fund
¾ Supply for venture capital
z Venture capital refers broadly to the pools of capital managed by
venture capitalists who seek to identify companies that have great
business opportunities but need financial, managerial, and strategic
support.
9 Venture capitalists invest alongside company managers, they often
take representation on the board of directors of the company, and
provide expertise in addition to capital;
9 Venture capital funds may be private partnerships, closely held
corporations, or publicly traded corporations.
z Large companies: A variety of major companies invest their own money
via corporate private equity in promising young companies in the same
or related industries.
9 This activity is known as corporate venturing, and the investors are
often referred to as “strategic partners”. Corporate venturing are not
available to public.
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Private equity / buyout funds
¾ Buyout funds
Private equity / buyout funds
¾ Dividend recapitalization
z Buyout funds are the largest segment of the private equity market as
z A method by which a buyout fund can realize the value of a holding
measured by AUM or size of capital commitments. Buyout funds may be
involves the issuance of debt by the holding to finance a special
divided into two major groups, mega-cap buyout funds and middle
dividend to owners. Dividend recapitalizations have at times allowed
market buyout fund;
z Mega-cap buy-out funds take public companies private;
z Middle-market buy-out funds purchase private companies whose
revenues and profits are too small to access capital from public equity
markets. They typically purchase established businesses, such as small
privately held companies (including those with venture capital support)
buyout funds to recoup all or most of the cash used to acquire a
company within two to four years of the buyout;
z Buyout funds remains ownership and control of the company;
z Dividend recapitalization has the potential to weaken the company as
a going concern by overleveraging it.
and divisions spun off from larger companies;
z Buyout funds can realize value gains through a sale of the acquired
company, an IPO, or a dividend recapitalization.
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Private equity – convertible preferred stock
¾ Types of investments
z Direct VC investment is structured as convertible preferred stock;
z The terms of the preferred stock require that the corporation pay cash
equal to some multiple (e.g., 2×) of preferred shareholders’ original
investment before any cash can be paid on the common stock;
z Typically, investors in subsequent rounds of financing receive preferred
stock with a claim that is senior to any previously issued preferred
stock. Seniority is included to entice subsequent investors and makes
those preferred shares more valuable than those issued earlier;
z All else being equal, preferred shares issued in later rounds are more
valuable than preferred shares issued in earlier rounds, which in turn,
are more valuable than the founders’ common shares. However, the
differences in values are slight and are frequently ignored in valuation;
z For convertible preferred shares issued in any round, an event such as
buyout or an acquisition of common equity at a favorable price will
trigger conversion of the preferred shares into common shares.
Private equity funds – structures
¾ Indirect investment is primarily through private equity funds
¾ Legal structure of private equity funds
z Private equity funds are usually structured as limited partnerships or
limited liability companies ( LLCs ) with an expected life of 7-10 years,
and an option to extend the life for another 1-5 years;
z These legal structures ensured that the limited partners or shareholders
do not bear any liability beyond the amount of their investments and
avoid possible double taxation which could occur in corporate forms;
z The general partner (in an LC, the managing director) “takes down” the
investment made by LP over time in a series of capital calls. The general
partner (or the managing director) is the venture capitalist, the party
selecting and advising investments;
z The general partner, who might be an individual, a corporation or a
partnership, also commits its own capital. The interests of outside
investors and fund manager are closely aligned;
z The timeline starts with the general partner/managing director getting
commitments from investors at the beginning of the fund and then
giving "capital calls" over the first five years (typically), which are referred
to as the commitment period.
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Private equity funds – fees
¾ Fee structures of a private equity fund
z The compensation to the fund manager of a PE fund consists of a
management fee plus an incentive fee.
9 The management fee is typically 1.5-2.5 percent range.
‹
Based upon the committed fund, not just funds already
invested. The percent may decline over time based upon the
assumption that the manager’s work load declines over time.
9 The incentive fee, also the carried interest, is the share of the
private equity’s profits. Carried interest is usually around 20% of
fund’s profits.
‹
In some funds, the carried interest is computed on only those
profits that represent a return in excess of a hurdle rate.
‹
Private equity funds sometimes have a claw-back provision
that specifies that money paid to the fund manager be returned
to investors if at the end of a fund’s life investors have not
received back their capital contributions and contractual share
of profits.
Private equity funds – fees
¾ Fee structures of a private equity fund
z Fee structures of private equity funds of funds
9 Private equity funds of funds invest in other private equity funds;
9 Management fees range from 0.5%-2% of net asset managed.
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Private equity / VC
Private equity / VC
¾ Investment characteristics for private equity investments
z Illiquidity;
z Long-term commitments required;
z Higher risk than seasoned public equity investment;
z Higher IRR required.
¾ Investment characteristics for venture capital investments
z Limited information.
¾ Differences in return characteristics of VC funds and buyout funds
z Buyout funds are usually highly leveraged;
z The cash flows to buyout fund investors come earlier and are often
steadier than those to VC fund investors;
z The returns to VC fund investors are subject to greater measurement
error.
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¾ Roles in portfolios
z Private equity play a moderate role as a risk diversifier, but many
investors look to private equity investment for long-term return
enhancement;
z Issues to be addressed in formulating a private equity investment
strategy
9 Ability to achieve sufficient diversification: A private equity fund
of funds is a possible diversification choice, although it involves a
second layer of fees;
9 Low liquidity of the position: Direct private equity investments are
inherently illiquid. Investors in funds must be prepared to have the
capital tied up for 7–10 years;
9 Provision for capital commitment: The investor needs to make
provisions to have cash available for future capital calls;
9 Appropriate diversification strategy: Knowing the unique aspects
of a proposed private equity investment as well as the effect of that
investment on the overall risk of the portfolio.
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Private equity
Historical performance – PE
¾ Benchmarks of private equity
z Benchmarks
9 Provided by Cambridge Associates, Preqin, and LPX.
z Construction
9 Indexes often consist of an overall private equity index representing
two major segments, VC funds and buyout funds, plus a number of
sub-indexes.
z Biases
9 Infrequent market pricing poses a major challenge to index
construction.
¾ PE
z Since when measuring the performance of a private equity investment,
investors typically calculate an internal rate of return based on cash
flows since inception of the investment and the ending valuation of the
investment (the net asset value or residual value).
z In the following Exhibit, “balanced VC funds” are funds that make both
early-stage and late-stage investment.
¾ US private equity returns as of 30 September 2014 (%).
Period
Venture Capital Funds
NASDAQ S&P 500
Late
Stage
MultiStage
3 Years
15.7
13.7
15.0
17.9
23.0
23.0
5 Years
15.5
17.5
13.3
17.2
16.2
15.7
10 Years
9.3
13.2
10.0
14.0
9.0
8.1
20 Years
53.9
11.5
13.4
n/a
9.3
9.6
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Growth
Equity
EarlyStage
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Commodity
Commodity
¾ Types: There are two broad approaches to investing in commodities:
direct and indirect.
z Direct commodity investment entails cash market purchase of physical
commodities – agriculture products, metals, and crude oil – or exposure
to changes in spot market values via derivatives.
9 Shortage of cash market purchase: It involves actual possession and
storage of the physical commodities and incurred carry costs and
storage costs. Thus investors have generally preferred to use
derivatives or indirect investments.
z Indirect commodity investment, involves the acquisition of indirect
claims on commodities, such as equity in companies specializing in
commodity production.
9 However, that indirect commodity investment – in particular, equity
instruments in commodity-linked companies – does not provide
effective exposure to commodity price changes;
9 This fact has been a spur to the creation of investable commodity
indices and a current preference for gaining exposures to
commodities through derivative markets.
¾ Investment characteristics
z Special risk characteristics
9 Commodities have tended to have correlation with equities and
bonds that are unusually low;
9 Commodities are generally business-cycle sensitive;
9 Commodities correlate positively with inflation whereas stocks
and bond are negatively correlated with inflation.
z Commodities as an inflation hedge
9 Storable commodities (gold, silver, zinc, aluminum, copper,
crude oil, heating oil and natural gas) directly related to the
intensity of economic activity exhibit positive correlation with
unexpected inflation;
9 Tend to increase in value with unexpected increase in inflation;
9 Non-storable commodities (livestock, wheat, corn) tend to
exhibit the opposite behavior.
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Commodity
Commodity
¾ Components of return for commodity future contracts
z A total return for a future contract can be decomposed into 3 parts: the
spot return, the collateral return and the roll return.
¾ Upward or downward sloping term structure
z A major consequence of a downward-sloping term structure of futures
prices is the opportunity to capture a positive roll return as investment
in expiring contracts is moved to cheaper new outstanding contracts.
z A upward-sloping typically implies a negative roll return.
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¾ Benchmarks of commodities
z Benchmarks
9 Reuters/Jefferies Commodity Research Bureau (RJ/CRB) Index;
9 The S&P Goldman Sachs Commodity Index (GSCI);
9 The Bloomberg Commodity Index (BCOM).
z Construction
9 A variety of indexes based on futures prices can be used as
benchmarks for the performance of futures-based commodity
investments.
9 All of these indexes are considered investable.
z Biases
9 These and other commodity indexes vary greatly in their
composition and weighting schemes.
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Historical performance – commodities
Historical performance – commodities
¾ Commodity index performance 1996-2015.
Bloomberg
Barclays US
Government
Bloomberg
Barclays US
Aggregate
Bloomberg
Barclays
US
Corporate
High Yield
8.51%
5.02%
5.37%
6.75%
22.79%
15.31%
4.08%
3.47%
9.09%
-0.04
0.56
1.23
1.55
0.74
-79.44%
-50.95%
-4.64%
-3.83%
-33.31%
0.25
-0.10
-0.01
0.28
Stock, Bond, And
Commodity Index
Performance
S&P
CSCI TR
S&P
Annualized Total
Return
-1.01%
Annualized
Standard Deviation
Mean Return-toVolatility Ratio
Maximum
Drawdown
¾ Commodities performance in portfolios, 1996-2015.
Correlation with
Commodity Index
A
B
C
D
Annualized Return
Portfolios
7.26%
6.65%
7.92%
7.22%
Standard Deviation
7.83%
7.91%
8.38%
8.50%
0.93
0.84
0.94
0.85
-27.11%
-30.13%
-32.08%
-34.31%
Mean Return-toVolatility Ratio
Maximum
Drawdown
Correlation with
Hedge Funds
Portfolio A
Portfolio B
Portfolio C
Portfolio D
0.24
Equal weights S&P 500 and Bloomberg Barclays US Aggregate
Bond Index.
90% Portfolio A and 10% commodity index.
75% Portfolio A and 25% CTA/hedge funds/private equity/real
estate.
90% Portfolio C and 10% commodity index.
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Historical performance – commodities
Hedge fund
¾ Commodities performance in portfolios, 2001-2015.
A
B
C
D
Annualized Return
Portfolios
5.34%
4.77%
6.24%
5.39%
Standard Deviation
7.54%
7.81%
8.45%
8.68%
0.74
0.61
0.74
0.62
-27.11%
-30.13%
-32.08%
-34.31%
Mean Return-toVolatility Ratio
Maximum
Drawdown
Correlation with
Hedge Funds
Portfolio A
Portfolio B
Portfolio C
Portfolio D
0.29
0.30
0.34
Equal weights S&P 500 and Bloomberg Barclays US Aggregate
Bond Index.
90% Portfolio A and 10% commodity index.
75% Portfolio A and 25% CTA/hedge funds/private equity/real
estate.
90% Portfolio C and 10% commodity index.
¾ Types of hedge fund investments – classified based on styles, method I
z Equity market neutral attempts to identify overvalued and
undervalued equity securities while neutralizing the portfolio’s
exposure to market risk through combining long and short positions.
z Convertible arbitrage: Strategies attempt to exploit anomalies in the
prices of corporate convertible securities, such as convertible bonds,
warrants, or convertible preferred stock.
9 Example: Buy convertible bonds and hedging the equity component
of the bond’s risk by shorting the associated stock;
9 The investor gains from increases in the value of the convertible, the
short rebate (i.e., interest on short-sale proceeds) and/or further
decline in the stock price.
z Fixed-income arbitrage: Managers dealing in fixed-income arbitrage
attempt to identify overvalued and undervalued fixed-income
securities, primarily on the basis of expectations of changes in the term
structure of interest rates or the credit quality of various related issues or
market sectors.
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Hedge fund
Hedge fund
z Distressed securities investments can be invested in both debt and
equity of companies that are in or near bankruptcy. Most investors are
unprepared for the legal difficulties that are common with distressed
companies. Because of the relative illiquidity of distressed debt and
equity, short sales are difficult, so most funds are long;
z Merger arbitrage or deal arbitrage seeks to capture the price spread
between current market prices of corporate securities and their value
upon completion of a takeover, merger, spin-off, or similar transaction
involving more than one company;
z Hedged equity strategies (a.k.a. equity long-short) attempt to identify
overvalued and undervalued equity structures. Portfolios are
typically not structured to be market, industry, sector, or dollar neutral.
For example, the value of short positions may be only a fraction of the
value of long positions and the portfolio may have a net long exposure
to the equity market. Hedged equity is the largest of the various hedge
fund strategies in terms o assets under management.
z Global macro strategies take advantages of systematic moves in
major financial and non-financial markets through trading in currencies
and derivatives, although they may also take major positions in equity
and bond markets. For the most part, they differ from traditional hedge
fund strategies in that they concentrate on major market trends rather
than on individual security opportunities. Managed futures are
sometimes classified under global macro;
z Emerging markets funds focus on emerging and less mature markets.
They tend to be long, and often short selling is not permitted in most
emerging markets and options are not available;
z Fund of funds (FOF) is a fund that invests in a number of underlying
hedge funds. They can be of varying styles or not.
9 Although FOFs investors can achieve diversification, they have to
pay two layers of fees – one to the hedge fund manager, the
other to the FOF manager;
9 Returns on funds of funds are found to be more positively
correlated with equity market than with returns on individual
hedge funds.
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Hedge fund
Hedge fund
¾ Types of Hedge fund investments – classified based on styles, method
II
z Relative value strategies, in which the manager seeks to exploit value
discrepancies through long and short positions.
9 This label of strategy may be used as super-category for equity
market neutral, the convertible arbitrage, and fixed income arbitrage.
z Event-driven strategies focus on opportunities created by corporate
transactions, e.g. merger (merger arbitrage), or the turnaround of a
distressed company (distressed securities).
z Equity hedge, in which the manager invests in long and short equity
positions with varying degrees of equity market exposure and leverage.
z Global asset allocators, which are opportunistically long and short a
variety of financial and/or non-financial assets;
z Short selling, in which the manager shorts equities in the expectation
of a market decline.
¾ Compensation structure of hedge funds
z Asset-under-management (AUM) fee generally ranges from 1 percent
to 2 percent;
z Incentive fees : The incentive fee is a percentage of profits as specified
by the terms of the investment; it has traditionally been 20%.
z High-water marks
9 The purpose of a high-water mark is to ensure that the hedge fund
manager earns an incentive fee only once for the same gain. Hedge
fund investors also often take the opportunities offered them to
withdraw capital from a fund on a losing streak.
z Lock-up period
9 A minimum initial holding period for investments during which no
part of the investment can be withdrawn. (typically 1-3 years).
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Hedge fund – other issues
¾ Fund of funds
Hedge fund – other issues
¾ Hedge fund performance evaluation
z Diversification
z Conventions
z Two layers of fees
9 Performance fees;
z Offer additional liquidity
9 Lock-up period;
z The FOF manager must hold a cash buffer that may reduce expected
returns
9 Age (vintage) effects;
9 Fund size;
z Popular as entry-level investments
9 Empirical studies have found that
z Less survivorship bias and backfill bias
‹Funds with quarterly lock-ups have higher returns than similar-
z Provide a more accurate prediction of future fund returns
strategy funds with monthly lock-ups;
z Suffer from style drift
‹Young funds outperform old funds on a total-return basis;
z More highly correlation with equity markets澝
‹On average, large funds underperform small funds.
z No lock-up period or minimum lock-up period
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Hedge fund
Hedge fund
¾ Hedge fund performance evaluation
z Special issues
9 Return: inflows and outflows’ impact (GIPS);
9 Leverage: as if the asset was fully paid for;
9 Volatility: hedge funds appear to have more instances of extremely
high and extremely low returns than would be expected with a
¾ Hedge fund performance evaluation
z Sharpe ratio = (annualized rate of return – annualized risk-free
rate)/annualized standard deviation
9 Definition
9 Limitation
‹Time dependent (the overall sharp ration increases
proportionally with the square root of time);
normal distribution (i.e., positive excess kurtosis) and some funds
‹Has an asymmetrical return distribution;
also display meaningful skewness;
‹Illiquid holding bias;
9 Downside deviation computes deviation from a specified threshold
(i.e., below a specified return); only the negative deviations are
included in the calculations.
‹Is overestimated when investment returns are serially correlated;
‹Is primarily a risk-adjusted performance measure for standalone investments and does not take into consideration the
correlations with other assets in a portfolio;
‹Has not been found to have predictive ability for hedge funds.
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Hedge fund——rolling return
Month
January
February
March
April
May
June
July
August
September
October
November
December
Hedge Fund Returns(%)
3.50
4.00
–2.00
–2.00
–1.00
0.90
–1.00
1.70
2.70
3.70
0.40
–3.20
Hedge fund——rolling return
¾ Solutions:
Index Returns (%)
–2.40
–4.00
–1.60
3.00
–4.20
2.00
2.50
–2.10
–2.00
0.50
3.10
0.20
z A. The hedge fund’s average nine-month rolling return:
RR 9,1 = 2.7+1.7-1+0.9-1-2-2+4+3.5 /9=0.7556%
RR 9,2 =0.7778%
RR 9,3=0.3778%
RR 9,4 =0.2444%
Average= 0.7556+0.7778+0.3778+0.2444 /4=0.54%
z B. Rolling returns can show how consistent the returns are over the
investment period and whether there is any cyclicality in the
returns.
¾ A. Calculate the average rolling returns for the hedge fund if the
investor’s investment horizon is nine months.
¾ B. Explain how rolling returns can provide additional information
about the hedge fund’s performance.
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Hedge fund
Hedge fund
¾ Benchmarks of hedge funds
z Biases
9 Relevance of past data on performance: research has shown that
the volatility of returns is more persistent through time than the
level of returns.
9 Popularity Bias: the indexes that are value weighted may reflect a
given style’s popularity with investors because the asset values of
the various funds change as a result of asset purchases and price
changes.
9 Survivorship bias: results when managers with poor track records
exit the business and are dropped from the database whereas
managers with good records remain.
9 Stale Price Bias: bias that arises from using prices that are stale
because of infrequent trading.
9 Backfill Bias (Inclusion Bias): it can result when missing past return
data for a component of an index are filled in at the discretion of the
component when it joins the index.
¾ Benchmarks of hedge funds
z Benchmarks
9 CISDM;
9 Credit Suisse;
9 Hedge Fund Intelligence;
9 HedgeFund.net;
9 HFR;
9 Morningstar MSCI.
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Historical performance – hedge fund
Historical performance – hedge fund
¾ Hedge fund performance, 1996-2015.
Measure
Annualized
Return
Annualized
Std. Dev.
Mean
Return-toVolatility
Ratio
Maximum
Drawdown
Correlation
with Hedge
Funds
Hedge
Funds
S&P
500
Bloomberg
Barclays US
Aggregate
¾ Performance of hedge fund strategies and traditional assets, 1996 – 2015.
Comm
odities
CISDM
CTA EW
Real
Estate
Private
Equity
9.15%
8.51%
5.37%
-1.01%
7.22%
10.32%
8.23%
7.36%
15.31%
3.47%
22.79%
8.54%
19.47%
27.17%
1.24
0.56
1.55
-0.04
0.85
0.53%
0.30
-21.71% -50.95%
1.00
0.74
-3.83%
0.00
-79.44% -11.93%
0.25
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-0.05
-67.89% -80.44%
0.57
0.75
General situation of stock markets in developed countries.
CISDM Equal
Weighted
Hedge Fund
Index
CISDM Equity
Market Neutral
Index
CISDM
Convertible
Arbitrage Index
Annualized
Return (%)
Standard
Deviation
(%)
Mean
Return-toVolatility
Ratio
Correlation
with S&P
500
Correlation
with
Barclays US
Corp High
Yield
9.15
7.36
1.24
0.74
0.64
7.38
2.21
3.35
0.40
0.34
8.03
5.00
1.61
0.45
0.71
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Historical performance – hedge fund
Managed futures
¾ Performance of hedge fund strategies and traditional assets, 1996 – 2015.
¾ Managed futures are private pooled investment vehicles that can invest
in cash, spot, and derivative markets for the benefit of their investors and
General situation of stock markets in developed countries.
Annualized
Return (%)
Mean
Return-toVolatility
Ratio
Standard
Deviation
(%)
Correlation
Correlation
with
with S&P Barclays US
500
Corp High
Yield
have the ability to use leverage in a wide variety of trading strategies.
¾ Managed futures vs. hedge funds
z Similarities
9 Managed futures programs are often structured as limited
partnerships open only to accredit investors;
9 Compensation arrangements for managed futures programs are
CISDM
Global
Macro Index
6.29
CISDM
Equity
Long/Short
Index
8.88
3.93
1.60
0.39
0.29
also similar to those of hedge funds;
9 Like hedge funds, managed futures programs are actively managed;
9 Like hedge funds they are usually classified as absolute return
7.47
1.19
0.75
0.54
strategies;
9 There is also more than one way to categorize subgroups.
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Managed futures
Managed futures
¾ Managed futures vs. hedge funds
¾ In the United States, such programs are run by general partners known as
Commodity Pool Operators (CPOs), who are, or have hired professional
z Differences
9 For the most part, managed futures trade exclusively in derivative
markets whereas hedge funds tend to be more active in spot
markets while using futures market for hedging;
9 Hedge funds often trade in individual securities whereas managed
futures primarily trade market-based futures and options contracts
on broader or more generic baskets of assets;
9 One can view hedge funds as concentrating on inefficiencies in
micro (security) stock and bond markets whereas managed futures
look for return opportunities in macro (index) stock and bond
markets.
Commodity Trading Advisors (CTAs) to manage money in the pool.
¾ Types of managed futures investments – classified by investment style
z Systematic trading strategies primarily follow a rule-based trading
model, usually based on past prices.
9 Most systematic CTAs invest by using a trend-following program,
although some trade according to a contrarian, or countertrend,
program.
z Discretionary trading strategies trade financial, currency, and
commodity futures and related options.
9 Unlike systematic strategies, they involve portfolio manager
judgment.
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Managed futures
¾
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Managed futures
Investment characteristics
z Derivative markets are “zero-sum” games . As a result, the long-term
return to a passively managed, unlevered futures position should be the
risk-free return on invested capital less management fees and
transaction costs.
z For derivative-based investment strategies like managed futures to
produce excessive returns, on average, there must be a sufficient
number of hedgers or other users of the markets who systematically
earn less than the risk-free rate. Hedgers, for example, may pay a risk
premium to liquidity providers for insurance they obtain.
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¾ Investment characteristics (cont’d)
z CTAs attempt to conduct arbitrage when relationships are out of
equilibrium (short-term pricing discrepancy between theoretically
identical stock, bond, futures, options, and cash market positions);
z Most actively managed derivative strategies follow momentum
strategies (take advantage of trading opportunities in trending markets);
z Strategies not available to all investors.
9 Because of the ease with which futures traders take short positions,
futures traders can attempt to earn positive excess returns in falling
markets. Some of the most impressive returns for CTAs have been
during periods of poor performance in equity markets (e.g. Oct
1987);
9 Access to option markets permit managed futures and hedge fund
traders to create positions that attempt to exploit changes in
market volatility (one of the determinants of option value) of the
underlying asset.
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Managed futures
Managed futures
¾ Roles in the portfolio
z Managed futures appear to be useful in diversifying risk even in a
diversified portfolio of stocks, bonds, and hedge funds.
9 On the one hand, a number of studies found that publicly
traded commodity funds have been poor investments either on
a stand-alone basis or as part of a diversified portfolio;
9 On the other hand, some research has concluded that private
commodity pools and CTA-based managed accounts do have
value either as stand-alone investments, as part of a portfolio, or
in both roles.
¾ Benchmarks of managed futures
z Benchmarks
9 Mount Lucas Management Index;
9 CISDM CTA.
z Construction
9 The Mount Lucas Management Index replicate the return to a
mechanical, trend-following strategy in a number of financial and
commodity futures markets.
9 The equal-weighted CISDM CTA Equal Weighted Index reflects
manager returns for all reporting managers in the CISDM CTA
database.
z Biases
9 Upward bias that survivorship can impart.
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Distressed securities
Distressed securities
¾ Distressed securities are the securities of companies that are in
financial distress or near bankruptcy.
¾ Investors may access distressed securities investing through two chief
structures.
z Hedge fund structure: this is the dominant type. The AUM fee and
incentive structure, particularly when there is no hurdle rate associated
with the incentive fee, may be more lucrative than with other structures.
z Private equity fund structure: private equity funds have a fixed term
and are closed end. An NAV fee structure may be problematic when it is
difficult to value assets. When assets are illiquid, hedge fund-style
redemption rights may be inappropriate to offer.
z There are also structures that are hybrids of the hedge fund and private
equity fund structures.
¾ Types of assets distressed securities manager may trade or invest in
z The publicly traded debt and equity;
z Orphan equity: newly issued equity of a company emerging from
reorganization that appears to be undervalued;
z Bank debt and trade claims
9 Because banks and suppliers owed money by the distressed
company may want to realize the cash value of their claims;
9 When the company is in reorganization, these instruments would be
bankruptcy claims.
z “Lender of last resort” notes;
z A variety of derivative instruments for hedging purposes – in particular,
for hedging the market risk of a position.
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Distressed securities
Distressed securities
¾ Investment characteristics
z Many investors are unable to hold below-investment-grade securities
because of regulatory or investment policy restrictions;
z Old equity claims may be wiped out in a reorganization, replaced by
new shares issued to creditors, and sold to the public as the company
emerges from reorganization. These shares may be shunned by
investors and analysts, and thus might be mispriced;
z A common theme in distressed securities investing is that it often
demands access to specialist skills and deep experience in credit
analysis and business valuation;
z This type of investment inherits the illiquidity characteristics specified
in the structure of the vehicle;
z Return distribution has negative skewness and positive kurtosis.
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¾ Roles in Portfolio – strategies available and risk characteristics
¾ Strategies of distressed securities investing
z Long-only value investing: Invest in perceived undervalued distressed
securities in expectation that they will rise in value.
9 High-yield investing: When the distressed securities are public debt;
9 orphan equity investing: Equity of firm emerging from reorganization.
z Distressed debt arbitrage: Purchasing a company’s distressed debt and
selling the company’s equity short. This approach has been popular with
hedge funds.
9 If the firm’s prospects worsen, the debt and equity will both fall in value.
The equity should decline more in value though;
9 If the firm's prospects improve, the debt will appreciate at a higher rate
than equity, (hedge fund manager usually attempt to buy the debt at
deep discounts at first), because the initial benefits of a credit
improvement accrue to bonds as senior claims. Company will have already
suspended any dividends while debt-holders will receive accrued interest.
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Distressed securities
Distressed securities
¾ Strategies of distressed securities investing (cont’d)
z Private equity, also called “vulture funds”, an “active” approach as it
involves corporate activism.
9 The investor usually becomes a major creditor of the target company
to obtain influence from board of directors or credit committee (buys
debt at deep discounts);
9 The investor then influences and assists in the recovery or
reorganization process; (to increase the value of the troubled company
by deploying the company’s assets more efficiently then in the past).
z A variation of active approach: Convert distressed debt to private equity in
a prepackaged bankruptcy.
9 The investor takes a dominant position in distressed debt of a public
company, seeks to have a prepackaged bankruptcy in which the investor
becomes the majority owner of a private company on favorable terms
(previous equity-holders are wiped out);
9 After restoring the company to better health, the firm has a company
that can be sold to private or public investors.
¾ Risks in distressed debt investing
z Event risk;
z Market liquidity risk;
z Market risk;
z J factor risk (judge factor risk).
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Distressed securities
Historical performance – distressed securities
¾ Benchmarks of distressed funds
z Benchmarks
9 All the major hedge fund indexes that we discussed in the hedge
fund section have a sub-index for distressed securities;
‹For example, the Credit Suisse, CISDM, and HFR indexes all have
distressed securities sub-indexes.
z Construction
9 Distressed bonds constitute the highest-credit-risk segment of the
high-yield bond market. Furthermore, distressed securities include
distressed equities and strategies based on these instruments.
z Biases
9 Self-reporting;
9 Backfill or inclusion bias;
9 Survivorship bias.
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It’s not an end but just the beginning.
Search for knowledge, read more, sit on your front porch and admire the
view without paying attention to your needs.
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ӹङ௎ްͫЉ੽٫ЇѠѾԅӯङ‫ࡣ۝‬澞
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¾ Distressed security
z The returns on distressed securities investing can be quite rewarding,
but the negative skewness indicates that, for distressed securities, large
negative returns are more likely than large positive returns.
z The Sharp ratio, which is based on the normal distribution assumption,
may not capture the complete risk-return trade-off of distressed
securities investing.
z The Sharp ratio for the HRF Distressed Securities Index is 1.59, which is
greater than the ratio for all the other assets. High mean returns with
low standard deviation seem to be an attractive characteristic of this
strategy.
z An important risk factor that may not be captured by the performance
data is event risk. The ability to correctly predict whether an event will
occur will ensure the success of the strategy.
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